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Maintain inflation target at 4% … if it ain’t broke, don’t fix it: RBI paper

The study said aiming for a lower rate could impart deflationary bias to the monetary policy.

By: ENS Economic Bureau | Mumbai | December 29, 2020 4:16:35 am
The concept of trend or steady state inflation, the level to which actual inflation outcomes are expected to converge after short run fluctuations from a variety of sources, including shocks, die out.

An RBI study has said maintaining 4 per cent inflation is appropriate for India as targeting a lower rate could impart deflationary bias to the monetary policy.

“The weighted average trend inflation — our preferred trend inflation estimates — declined from above 5 per cent until Q2 of 2008 to around 5 per cent by 2009,” the Reserve Bank of India (RBI) paper said. It eased steadily thereafter and remained at 4.3 per cent in Q1 of 2020, the paper, authored by RBI official Harendra Kumar Behera and Deputy Governor Michael Debabrata Patra, said.

“An increase in sacrifice ratio — further disinflations will become costlier in terms of the output foregone. At the same time, the credibility bonus accruing to monetary policy warrants smaller policy actions to achieve the target. This points to maintaining the inflation target at 4 per cent into the medium-term. If it ain’t broke, don’t fix it,” the paper said.

The concept of trend or steady state inflation, the level to which actual inflation outcomes are expected to converge after short run fluctuations from a variety of sources, including shocks, die out.

“It is worthwhile to note that trend inflation still remains above the target under flexible inflation targeting (FIT), although it is on a declining trajectory. This indicates that inflation expectations are not yet fully anchored to the target but convergence is underway,” the paper said. Underlying this is a decline in the inflation persistence, indicating that households and businesses in India are becoming more forward looking than before as credibility associated with monetary policy increases, it said.

“Understanding persistence or the tendency of inflation to converge slowly to its trend is also critical to fashioning appropriate monetary policy responses in terms of the size and timing of policy actions,” the paper added.

“A target set below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative what the economy can intrinsically bear in order to achieve the target.

“Analogously, a target that is fixed above trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations. Trend inflation is an empirical question and choice of methodology is crucial if the estimate of trend inflation has to be precise,” the paper stated. Within the proliferation of work on the subject, there is a loose consensus that none of them can outperform the random walk model for forecasting purposes, it said.

For the setting of monetary policy, it is necessary to consider significant changes in the overall macroeconomic ecosystem in which monetary policy is conducted. Trend inflation was falling even ahead of the institution of FIT and the latter entrenched this tendency, as reflected in rising probability of trend inflation at 4 per cent in both filtered and smoothed posterior estimates, it said. “The probability-weighted 16 average of trend inflation has come down from around 5 per cent until 2014 when the pre-conditions of FIT were beginning to 4.1-4.3 per cent in Q12020, just before Covid struck.”

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