The recent surge of inflation in India has forced the researchers to revisit the feasibility of Inflation Targeting (IT) in India as it is advocated as a framework which would provide a transparent monetary policy framework and thus would send clear signals to market participants regarding the stand of central bank vis-a-vis inflation. With this approach, the central bank commits to a numerical target of annual inflation which makes price stability as the primary goal. In addition, the inflation forecast over a time horizon acts as an intermediate target. Thus, inflation targeting becomes forward looking in nature and therefore allows policy makers to respond to economic shocks more flexibly.
The experience of the 23 countries practicing inflation targeting such as New Zealand, UK, Brazil, Chile, Republic of Korea et cetera suggests that inflation targeting helps not only in lowering inflation but also lowers inflation expectations and inflation volatility. There have also been no visible adverse effects on other macro economic parameters like output, interest rate and exchange rate. But in India the adoption of inflation targeting has hit the road block due to the concern that its adoption and implementation necessitates a number of preconditions such as central bank independence, absence of fiscal dominance, technical capability to forecast inflation and financial market depth. And there is a perception that failure to meet any of these preconditions makes inflation targeting infeasible. However the experience of inflation targeting countries in Figure indicates that none of these countries met all these preconditions at the time of adoption.
Note : 0 : Poor Condition and 1 : Ideal Condition for adoption of inflation targeting. Source: Batini et al (2006), IMF
An analysis of policy developments in India would suggest in favour of an inflation targeting framework. For example, in 2000, the Advisory Group on Transparency in Monetary and Financial Policies under the chairmanship of Mr. M Narsimhan recommended to pursue a single medium term inflation objective. This begins either with the finance ministry or with the RBI announcing occasionally a quantitative target for inflation, which can be converted to a regular policy exercise. Also as evidenced by the experience of other countries, the feasibility and success of inflation targeting depends on the commitment of the policy makers and their ability to bring the necessary institutional and technical changes in order to maximize the potential benefits of inflation targeting.
