Inflation Targating

Topics: Inflation, Central bank, Monetary policy Pages: 6 (1420 words) Published: December 11, 2014
Understanding inflation targeting
C. Rangarajan

nflation targeting is back in the news
and this is welcome. I have always held
the view that the dominant objective of
monetary policy is the maintenance of
price stability. Inflation targeting gives precision to the concept of price stability. In any monetary policy framework, a key
ingredient is an enunciation of its objectives.
This aspect has assumed increased significance in the context of the stress being laid on the autonomy of central banks. Autonomy
goes with accountability, and accountability
in turn requires a clear statement of goals.
The case of price stability as the major objective of economic policy rests on the assumption that volatility in prices creates uncertainties in decision-making. Rising prices adversely affect savings while making speculative investments more attractive. These apart, there is a crucial social dimension, particularly in developing countries. Inflation adversely affects those who have no hedges against it, and this includes all poorer sections

of the community. This is indeed a very strong
argument in favour of the maintenance of
price stability in emerging economies.

Price stability and growth
A crucial question that arises in this context
is whether the pursuit of the objective of price
stability by monetary authorities undermines
the ability of the economy to attain other
objectives such as growth. In short, the question is whether there is a trade-off between inflation and growth. There is a general consensus that over the medium and the long term, there is no such trade-off and an environment of low inflation is most conducive to faster economic growth. However, there could

be such a possibility in the short term. By
injecting greater demand and thereby generating higher inflation, higher growth may be achieved. However, to sustain this growth, the
authorities may have to generate higher and
higher inflation. This will end up as a selfdefeating exercise. What then is the tolerable level of inflation?


Inflation targeting re-emphasises the primacy of
price stability as the objective of monetary policy.
Given the rigidities in the economy and lags in
policy impact, it must be operated with flexibility

jectives from the purview of monetary
authorities so long as inflation remains within
the comfort zone. The control of inflation becomes its exclusive concern only when inflation crosses the acceptable level.

Can it be done?

Can the Reserve Bank of India (RBI) or for
that matter any central bank effectively implement an inflation mandate? Do they have enough instruments to achieve the goal? The
ability of the central banks to control inflation
when such inflation stems from excess demand is normally conceded. It is when inflation is triggered by supply shocks that some doubts are raised. Such supply shocks are
most common in countries like India where
agricultural production is subject to the vagaries of nature. Even when inflation is triggered by food inflation, monetary policy and fiscal policy have a role to play. If food inflation lasts long, it gets generalised. Wages Other objectives

rise leading to a general cost push inflation. If
Questions have been raised about the rohead line inflation exceeds the acceptable levbustness of such models. Even large econoel, monetary policy must act at least to ensure metric models are not in a position to capture

that the return on financial assets is positive
all the costs of inflation. This order of inflation
in real terms. In a situation of supply shocks, it
may take longer for monetary policy to bring
down inflation. The recent experience with
inflation in our country is a good example of
Apart from monetary policy, regulation of the financial
this. That is why the inflation mandate must
system, particularly the banking system, is entrusted to central provide for a range and a time frame for adjustment which should not be too short....
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