Inflation Targeting

Should the RBI give it up and focus only on growth?

Of late there has been a clamor from many economists and policy makers for RBI to give up on inflation targeting. What exactly does this mean? Inflation targeting is setting a medium term target of inflation and then using various tools to ensure price stability. Dr. Rajan has been a firm proponent of inflation targeting and most critics are of the view that inflation targeting comes at the cost of growth. Here are 3 reasons why inflation targeting must not be abandoned…

Gives a clear real return estimate

 Real returns on your investment is nothing but your nominal returns reduced by inflation. When individuals and institutions invest, it is based on estimated real returns. To predict real returns with a fair degree of accuracy, one needs to have a clear understanding of the likely rate of inflation. That is where inflation targeting comes in handy. For example, the RBI has set 5-6% as the range where it will target to keep inflation. This provides a worst-case scenario to an investor who needs to estimate real returns on a sustainable basis.  This makes investing a lot more predictable.

Imposes discipline on policy

 In the overall macroeconomic analysis, the level of fiscal deficit and the rate of inflation are closely inter-related. Fiscal deficit is the total borrowings of the government to bridge the gap between total receipts and total payments. When economies go berserk on their overall fiscal deficit it encourages them to spend even if it means resorting to borrowing. The inflation targeting strategy of the RBI has actually compelled the government to resort to fiscal deficit targeting. In the last Budget, the finance minister resisted the temptation to pump prime the economy at the cost of the fiscal deficit. This was necessitated only because the RBI had made inflation targeting its preamble.

Margin of safety for foreign flows

For a country that is constantly in need of foreign capital, sustaining flows becomes critical. Steady foreign inflows are predicated on a stable currency. One of the reasons the RBI has managed a calibrated depreciation of the INR is that inflation has been under control. If inflation goes up and the gap with global inflation widens, then there is pressure on the INR to weaken. We saw the outcome of such a policy in 2013 when debt investments to the tune of $12 billion left India in a short span of time. For global FDI and FPI flows, a stable currency is a necessity. That is only possible through very clearly focused inflation targeting. It may appear to cause pain in the short term, but inflation targeting is a must for India to maintain the sheen of economic attractiveness. The alternative could be actually much worse! ©

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