Goldman Sachs in a recent report suggested that the Reserve Bank of India should set a formal inflation'target' for increasing transparency in monetary policyand anchoring inflation expectations.
WHAT IS INFLATION TARGETING?
A central bank announces a mediumto long-term inflation 'target' and its subsequent monetary and interest rate policies are aimed at keeping inflation around this target.
Since the 1990s, many central banks in advanced and emerging economies have adopted explicit inflation targets as the most important goal of their monetary policy.
The central banks that do not set explicit targets tend to signal a comfort level of inflation. The US Federal Reserve followed this system until last year, indicating a long-run preference of 1.5%-2%. In January, in a significant shift, the Fed said it will target a long-run inflation of 2%.
HOW DOES AN EXPLICIT INFLATION TARGET HELP?
Economist say an explicit inflation target helps increase monetary policy transparency and predictability, besides anchoring inflation expectations.
For example, if the central bank of a country has an inflation target of, say, 2% and the actual inflation is more than this, market participants will know that the central bank will tighten monetary policy to rein in inflation.
In a reverse scenario, the bank will loosen monetary levers. This way the monetary policy becomes more predictable. And because of the predictability of action, inflation expectations are also tempered.
WHY HASN'T EVERY CENTRAL BANK ADOPTED EXPLICIT INFLATION TARGET?
The Federal Reserve of the US adopted an explicit inflation target only this year after extensive debate, suggesting that such an approach may not necessarily suit every country.
The support for inflation targeting is based on the view that if a central bank ensured price stability though an explicit inflation target, then there would be financial stability because market participants would act in a particular way.
However, the recent global financial crisis has dented this view somewhat. The financial crisis happened even while there was price stability.
Moreover, in many developing countries, apart from price management, the central banks also have to keep an eye on development issues, which means they have to worry about growth, spread of organised finance and ensure financial stability. An inflation centric approach could militate against these equally important roles of the central bank.
WHAT IS INFLATION TARGETING?
A central bank announces a mediumto long-term inflation 'target' and its subsequent monetary and interest rate policies are aimed at keeping inflation around this target.
Since the 1990s, many central banks in advanced and emerging economies have adopted explicit inflation targets as the most important goal of their monetary policy.
The central banks that do not set explicit targets tend to signal a comfort level of inflation. The US Federal Reserve followed this system until last year, indicating a long-run preference of 1.5%-2%. In January, in a significant shift, the Fed said it will target a long-run inflation of 2%.
HOW DOES AN EXPLICIT INFLATION TARGET HELP?
Economist say an explicit inflation target helps increase monetary policy transparency and predictability, besides anchoring inflation expectations.
For example, if the central bank of a country has an inflation target of, say, 2% and the actual inflation is more than this, market participants will know that the central bank will tighten monetary policy to rein in inflation.
In a reverse scenario, the bank will loosen monetary levers. This way the monetary policy becomes more predictable. And because of the predictability of action, inflation expectations are also tempered.
WHY HASN'T EVERY CENTRAL BANK ADOPTED EXPLICIT INFLATION TARGET?
The Federal Reserve of the US adopted an explicit inflation target only this year after extensive debate, suggesting that such an approach may not necessarily suit every country.
The support for inflation targeting is based on the view that if a central bank ensured price stability though an explicit inflation target, then there would be financial stability because market participants would act in a particular way.
However, the recent global financial crisis has dented this view somewhat. The financial crisis happened even while there was price stability.
Moreover, in many developing countries, apart from price management, the central banks also have to keep an eye on development issues, which means they have to worry about growth, spread of organised finance and ensure financial stability. An inflation centric approach could militate against these equally important roles of the central bank.
WHAT PATH DOES THE RBI FOLLOW?
In a big country like India that is gradually opening its door, the RBI has to worry about growth given the large-scale poverty, ensure a stable exchange rate, adequate foreign exchange reserves and provide stable financial markets.
Though these goals are not contradictory, at times the central banks need flexibility on the inflation side to adjust one of these objectives.
For instance, although inflation is running well above its comfort rate of around 5%, the RBI can still cut rates to stimulate growth as that is now being seen as a more pressing concern than price stability.
If the RBI was committed to an explicit inflation target of 5%, it would be in no position to relax the monetary policy.
In a big country like India that is gradually opening its door, the RBI has to worry about growth given the large-scale poverty, ensure a stable exchange rate, adequate foreign exchange reserves and provide stable financial markets.
Though these goals are not contradictory, at times the central banks need flexibility on the inflation side to adjust one of these objectives.
For instance, although inflation is running well above its comfort rate of around 5%, the RBI can still cut rates to stimulate growth as that is now being seen as a more pressing concern than price stability.
If the RBI was committed to an explicit inflation target of 5%, it would be in no position to relax the monetary policy.
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