Maintaining 4% inflation appropriate for India: RBI paper

The inflation target is likely to be retained at 4 per cent in the medium term, a Reserve Bank of India (RBI) working paper suggested on Monday. A 4 per cent inflation target for the Indian Monetary Policy Committee is just right as it matches with the average trend inflation measured since 2014, the research paper said.

The inflation target needs to be fixed in alignment with trend inflation to avoid unhinging inflation expectations and flattening the aggregate supply curve or imparting a deflationary bias to the economy, it said.

“Results from a regime-switching model applied to a hybrid New Keynesian Philips Curve (NKPC) suggest a steady decline in trend inflation since 2014 to 4.1-4.3 per cent just before covid-19 struck. This points to maintaining the inflation target at 4 per cent for India," the paper said.

NKPC is a widely used model of inflation dynamics, according to a European Central Bank’s working paper from 2007.

An inflation target set too much below the trend imparts a deflationary bias to monetary policy because it will go into overkill relative to what the economy can intrinsically bear to achieve the target, argued the paper by Behera and Patra.

“Analogously, a target that is fixed above the trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations," it said.

With India’s inflation as measured by consumer price index consistently remaining above RBI’s target since the outbreak of covid-19, experts have called for scrapping the target altogether.

The paper, authored by Harendra Kumar Behera and Michael Debabrata Patra, ended it by saying: “If it ain’t broke, don’t fix it".

Patra, a deputy governor at the central bank, is also part of the monetary policy committee (MPC) tasked with keeping inflation within the flexible target of 2-6 per cent.

The paper comes with the usual disclaimer that while the authors are from RBI, the views expressed are not necessarily those of the regulator.