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Inflation Targeting

Inflation Targeting

• Inflation targeting is a monetary policy where the central bank of a country targets a specific inflation rate for the medium-term. It has emerged as an important monetary policy framework to achieve price stability within an economy. Various contractionary and expansionary monetary policy tools are applied by the Central Bank while resorting to Inflation Targeting.

• In order to monitor and assess price movements across different sectors of the economy Central Banks often employ various inflation indices as benchmarks (For example Reserve Bank of India employs CPI (Combined) Base Year: 2011-12). The Currency and Finance Report (RCF) released by the Reserve Bank of India for 2020-21 states that the current inflation band (4% +/-2%) is appropriate for the coming five years.

• In essence, inflation targeting coupled with the use of inflation indices serves as a cornerstone for effective monetary policy implementation and economic stability.

How is Inflation Targeting done?

Inflation Targeting is done by raising or lowering interest rates based on above-target or below-target inflation, respectively. These policies are known as expansionary and contractionary monetary policies respectively. An expansionary monetary policy is characterized by injecting liquidity via lowering of interest rates thereby stimulating demand. On the contrary contractionary monetary policy aims at absorbing liquidity via higher interest rates leads to a moderation in demand. Monetary policies greatly affect the demand side of inflation.  

What are the benefits and drawbacks of Inflation Targeting?

Benefits:

Safeguarding Economic fundamentals against external and political compulsions.

Transparency and accountability while formulating policies.

Drawbacks:

Sole emphasis upon Inflation leads to a neglect towards other factors. Experts argue that this might undermine growth in the long run.

FAQ about Inflation Targeting

Q1 Why is inflation targeting important?

Both hyper-Inflation and deflation destabilise economies. Inflation Targeting enables the central banks to safeguard the economy against external as well as domestic shocks by keeping the inflation close to the agreed target.  

Q2 How does inflation targeting operate when there is inflation?

Central bank reduces interest rate if the economy is experiencing disinflation below the inflation target bracket. On the Contrary, interest rates are increased when the economy experiences inflation beyond the specific inflation bracket. In case of India the inflation target is 4% (+-2%).

Q3 Who sets the inflation target in India?

The inflation target in India is set together by the central bank of the country, which is the Reserve Bank of India and the government of India via Monetary Policy Commitee. This is based on the amended RBI Act, 1934.

Q4 What is the need for inflation targeting?

Inflation targeting brings stability, predictability, and transparency in deciding monetary policy. 

Q5 When was Inflation Targeting adopted in India?

In 2015, RBI and the central government agreed on a policy framework. Reserve Bank of India Act, 1934 was amended and the Flexible Inflation Targeting (FIT) framework was adopted in 2016.