Why in news?

The RBI, in its new discussion paper on the monetary policy framework, cautioned that raising India’s 4% inflation target now would undermine the credibility of the framework and risk reversing the macroeconomic stability gains achieved over the past decade.

What’s in Today’s Article?

• RBI’s Discussion Paper on Monetary Policy
• Headline vs. Core Inflation in Monetary Policy
• Recent Trends

RBI’s Discussion Paper on Monetary Policy

• The Reserve Bank of India (RBI) has released its long-awaited discussion paper on the country’s monetary policy framework.
• It warns that raising the current 4% inflation target could undermine the credibility of the framework and undo the policy and institutional gains achieved over the last decade.
• Key Questions for Feedback
  • The central bank has invited public feedback on four crucial issues:
    • Whether monetary policy should target headline or core inflation.
    • If the 4% inflation target remains optimal for balancing growth and stability.
    • Whether the 2–6% tolerance band needs revision or removal.
    • Whether the explicit 4% target should be dropped in favour of only a range.
• Risks of Raising or Lowering the Target
• The paper highlights that raising the target in today’s environment of global geopolitical and economic uncertainty could be interpreted as a dilution of the inflation targeting framework, weakening investor confidence.
• Conversely, lowering the target below 4% would not suit India’s current economic conditions.
• Recently, S&P Global Ratings upgraded India’s rating to BBB, praising the RBI’s strong record in inflation management.
• Stable inflation within the 2–6% range has been crucial for investor confidence, growth prospects, and currency stability.
• Background
  • India adopted the flexible inflation targeting framework in 2016, with a medium-term CPI target of 4% and a tolerance band of 2–6%.
  • The present target is valid till March 2026, after which it must be reset for the next five years.

Headline vs. Core Inflation in Monetary Policy

• The Economic Survey 2023-24 suggested that India’s inflation targeting framework should consider focusing on core inflation (excluding food and fuel).
  • Core inflation - A measure of inflation that excludes highly volatile components, typically food and energy prices. 
  • Headline inflation - The total inflation rate in an economy, encompassing the prices of all goods and services within the representative basket. 
• This was due to the fact that the food prices in India often rise due to supply shocks rather than demand pressures—making them less responsive to monetary policy tools.
• The RBI, under former Governor Shaktikanta Das, rejected this idea, stressing that food prices cannot be ignored.
• In its latest discussion paper, the RBI reiterated that nearly all inflation-targeting countries, regardless of their development stage, target headline CPI inflation.
  • Uganda is the only exception, focusing on core inflation.
• Spillover Effects of Food Prices
  • The RBI highlighted that persistent food inflation eventually spills over into core inflation through higher wages, rents, and business markups.
  • Empirical evidence from India shows that while core prices remain stable, non-core (food and fuel) prices tend to converge with them over the long run.
  • Hence, ignoring food inflation could weaken monetary policy effectiveness.

Recent Trends

• In July 2024, headline CPI inflation fell to 1.55%, an eight-year low, while core inflation stood at 4.1%.
• Historically, headline inflation has fluctuated widely between 1.5% and 8.6% since 2014 due to food price swings, whereas core inflation has been more stable.
• The RBI concluded that monetary policy must ensure both credibility and certainty, especially during global uncertainty.
• Therefore, it emphasised the importance of continuing with headline CPI as the target, since it better reflects the inflation experienced by households and investors.