The price moderation couldn’t come at a better time for central bank Governor Shaktikanta Das, with the inflation targeting mechanism that’s been in place since 2016 coming up for review this year. The RBI will give its official recommendations in an annual report due in the next few weeks.
Price pressures in India have for the most part been driven by factors beyond the central bank’s control: costlier food items, broken supply chains due to a strict lockdown, and hefty levies on already rising retail fuel prices. Crude oil, India’s top import has surged more than 40% since the end of October thanks to a series of vaccine breakthroughs, and the increase is an added threat to inflation, as also trade balance -- making the economy heavily reliant on foreign inflows in stocks and bonds to help finance import needs. Indian bonds saw outflows of more than $13 billion last year amid concerns a wider fiscal deficit and economic contraction will lead to the nation’s credit score being cut to junk.
“I don’t think this is the result of any significant policy errors,” said Hugo Erken, head of international economics at Rabobank in Utrecht. “But the RBI needs ways to restore faith of agents in the economy that 2%-6% is an inflation rate that will eventually be achieved.”
Flaw or not, India’s above target CPI has kept the RBI from adding to the 115 basis points of easing it delivered in the first half of 2020, although some of its peers across the Asia-Pacific were able to use the rate tool to support their economies, thanks to price-growth that was within or in line with target.
On his part, RBI Governor Shaktikanta Das is clear that anchoring inflation expectations is the RBI’s primary task so that policy credibility is not undermined. To that effect, he cautioned the government against loosening the current inflation target band, saying doing so would dilute its effectiveness toward setting monetary policy.
Critics, including some in Prime Minister Narendra Modi’s government, are seeking a widening of the inflation targeting band so the bank can focus on doing more to stimulate growth. Others are calling for policy to target core inflation, which strips out volatile food and energy prices, as well as the current benchmark headline inflation. Kaushik Das, chief India economist at Deutsche Bank AG in Mumbai, said given that underlying wholesale prices represent the manufacturing sector; it is rather “strange” that this isn’t included.
In the end, the Flexible Inflation Targeting regime, which has been successful in anchoring expectations, is likely to stay. A recent working paper from the International Monetary Fund on “India’s Inflation Process Before and After Flexible Inflation Targeting” found there is evidence that expectations have become more anchored since 2015.
“Central banks using FIT as a framework have a clear goal by adopting a nominal anchor rather than targeting intermediate variables, such as money supply, credit growth, which have an indirect relationship with price stability at best,” said Rabobank’s Erken. “Policy transparency enhances central bank credibility to such an extent that it leads to lower inflation expectations.