Inflation targeting in India: RBI's mandate must be modified

Barry Eichengreen, the well known economist, thinks inflation targeting is working in India and that it's good to stick to it. His views come at a time when the regime is seen to be coming in the way of cranking up growth just when the economy is suffering a huge contraction.

Eichengreen cites a co-authored paper of his which shows that the inflation targeting regime is "functioning well" in India. The RBI uses both price stability and growth to determine its policy rate. Policy has not become more hawkish after the regime was put in place. It has made for better anchoring of inflation expectations. Even when the inflation rate moves up, inflation expectations don't go up because people believe the RBI is capable of reining it in. In other words, the credibility of RBI has gone up consequent to inflation targeting.

Eichengreen, however, sees room for improvement especially in RBI's management of expectations of inflation. The data shows that while the RBI is able to manage expectations of professionals well, it hasn't done a great job of managing the expectations of ordinary people. He urges the RBI to reach out and better communicate to ordinary people.

All this is fine but the inflation targeting regime may still need modification. The problem thus far has not been with the inflation regime so much as how the RBI has interpreted it until recently. Although the upper limit for inflation in our regime is 6 per cent, the RBI chose to focus on a target of 4 per cent in practice. As the lower limit of 2 per cent is not particularly relevant now, why not make the mandate more specific by asking the RBI to limit inflation to 6 per cent instead of setting a band of 2-6 per cent?

Perhaps this can be done once the current spurt in inflation subsides and inflation falls below 6 per cent. The time to modify the regime is when the going is good, not when the going is bad. If the government moves to modify the inflation target at a time when the fiscal deficit of the centre and the states is poised to be rise to around 12 per cent of gdp and inflation is running above the limit of 6 per cent, it is unlikely to sit well with rating agencies and investors. At least one of the two closely watched indicators must look good before any change is attempted. 

Inflation must be kept under control. But inflation cannot be allowed to control macro-policy.