Inflation targeting is artfully designed as a monetary policy framework (see for example, the writings of Ben Bernanke, Lars Svensson) and not as a monetary policy objective. Inflation targeting is said to help the adopting countries to achieve their central bank’s final objective of price stability.

This has been adopted by a number of Western economies in the 1990s and thereafter with one exception, the US. Fears about inflation are real in the West ever since the German inflation of the 1920s and during the interwar years.

The boom period of the 1950s and 1960s subdued such fears somewhat but the high inflation rates in the 1970s mainly due to sharp oil price hikes and expansionist policies of central banks raised fears of inflation once again.

It is this experience that gave rise to the notion of inflation bias of central banks and setting up of rules for targeting inflation or an inflation range. Rules will be time consistent in contrast to discretion following the cues given by the seminal paper of Kydland Finn and Edward Prescott in the Journal of Political Economy, (Vol 85, 1977). Such inflation targeting would, it is further argued, be transparent and be able to influence market expectations of prospective policies or policy stance.

Common sense, however, shows that the analytical arguments in favour of inflation targeting cannot be easily defended on the basis of logic or at the current level of knowledge of econometric tests, the ground realities.

Monetary vs fiscal

At the outset, it needs to be recognised that monetary policy falls in the ambit of public finance and has to be integrated or coordinated with fiscal policy so as to lend credibility to market expectations about policy prospects. Policy expansion cannot therefore be undertaken by central banks alone in modern democratic societies.

Not unsurprisingly, the advocates of inflation targeting dismiss this idea by suggesting that it should be operated in a flexible manner, a tricky argument that would allow central banks to take into account multiple economic indicators and not merely the data about inflation or inflation persistence and growth.

The trick does not work, however, since central banks’ sway on the aggregate demand is limited without the fiscal and other policy support. And central banks cannot have much influence on aggregate supply either.

For instance, the Reserve Bank of India (RBI) would have to treat food and oil prices as largely exogenously determined.

Again, RBI cannot completely ignore global factors such as global financial stress or global supply chain disruptions or global geopolitical uncertainties or climate change.

Even the domestic markets would not be wholly swayed by inflation targeting, however flexible it is, in a globalised world and would be led by not only domestic economic outcomes and policies but also external factors.

The empirical evidence relating to the efficacy of inflation targeting in the last 8-10 years should also be viewed with circumspection.

For some, quality institutional setting is critical for taming inflation (See Costas Milas et al, Quarterly Review of Economics and Finance, Vol 97, 2024).

Empirical research

Empirical studies on inflation targeting have not been able to satisfactorily isolate its influence and the processes through which it works on the inflation-growth outcomes and other macroeconomic indicators in the ecosystem that is dominated by a number of imponderables that are not necessarily under the control of the central bank of the country.

The recent comprehensive study by Barry Eichengreen and Poonam Gupta in August 2024 on the subject (NCAER Working Paper 174) has done well to review the recent literature and discuss the issues relating to inflation targeting in India.

But it too has not explained how the transmission mechanism works and the extent of lags in policy efficacy.

On the other hand, Eichengreen and Gupta conclude that the regime has worked well but can be tweaked to improve its performance for instance through reduction of the weight of the food price inflation in the CPI inflation basket.

However, the many inflations, not merely headline inflation, namely, food inflation, oil inflation, urban inflation, non-food inflation and so on are not necessarily well linked. More fundamentally, one needs to ask as to how and why the persistence of all macroeconomic indicators tended to move within a short range in the last eight years.

Does it not show that macro and institutional factors, not merely inflation targeting, have worked well and have been able to address even the external uncertainties till now during the last 8-year period?

Does this not again raise the question that despite the use of the best of available econometric works on the empirical validity of inflation targeting, there is no definitive conclusion that inflation targeting is superior to constrained discretion which is what has been implied by its predecessor, namely, the multiple indicators approach.

However, there is no possibility of leaving at this point of time, the inflation targeting as monetary policy framework since it has been brought in through the amendment to the RBI Act in 2016. It is perhaps time to review it and see how it can be moulded into a more credible policy framework.

The writer, a former Executive Director at RBI, is an independent economic analyst. Views expressed are personal. (Through The Billion Press)

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