Inflation-targeting in India is premature

Mar 18 2014, 01:15 IST
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SummarySupply-side constraints, especially in food and fuel, that contribute to inflationary pressures cannot be addressed by the instruments wielded by RBI

The finance minister recently stated that the government would decide on an inflation target for RBI to follow. Earlier, the RBI Governor had observed that he was waiting for the government to approve the inflation-targeting regime for RBI. The Urjit Patel Committee Report, which primarily mentions the implementation of inflation-targeting for India, has proposed that the new consumer price index-combined (CPI) should be the nominal anchor for inflation-targeting in India. But herein is a flaw which needs careful examination both for its content and its timing.

Historically, inflation-targeting was popular with the central banks and international institutions for more than a decade, but only until 2008. In view of the recent financial crisis and rethinking of the economic strategies that went wrong before 2008 compels one to conclude that the role of economic blinkers that inflation-targeting imposed on the policy makers cannot be ignored in the great recession. It is for this precise reason that no new country has implemented inflation-targeting in recent years. In the case of India, there are a few more compulsions that need to be addressed. The most important consideration are supply-side constraints that contribute to inflationary pressures which cannot be addressed by the instruments wielded by RBI, especially for food items and fuel.

The food situation in general is grim, both in India and globally, and therefore, food prices are expected to be firm. The El Nino impact on monsoon is expected this year, affecting countries like India, Australia, Thailand, Indonesia, Vietnam, the Philippines and China, amongst others. The climatic pattern in India is also changing and the Centre has already cautioned the state governments to be prepared for the El Nino effect. In view of the fact that food prices are dependent on monsoons, such climate change phenomena are expected to put pressure on food prices. In addition, food prices are also impacted by the minimum support prices (MSP) prescribed for foodgrains which are under pressure for revisions, despite having risen significantly in recent years. The Food Security Act, 2013, (FSA) which has assured subsidised grains to nearly 80 crore people in the country is also expected to distort food prices. FSA has already begun to change the cropping pattern implying that land under grain cultivation will increase at the cost of other agricultural products, including vegetables. This is on the top of the shrinking of land availability for agriculture on account of expanding urbanisation. The

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