India transited to a flexible inflation targeting (FIT) regime on June 27, 2016, as partof the move to modernize monetary policy making. Since the adoption of FIT, thefocus of the monetary policy was to maintain Consumer Price Index (CPI)-basedinflation at 4 ± 2%. FIT aims ‘to maintain price stability while keeping in mind theobjective of growth’.
Prima facie, after FIT adoption, inflation and its volatility did come down. Consumerinflation fell to 3.9% on average in three years after implementation, from anaverage 7.3% in the four years preceding. This phenomenon was visible not only inheadline inflation but also in each of its key categories.
However, it is important to note, the sharp slowdown in food inflation, which isconsidered an idiosyncratic factor, has played an important role in driving headlineinflation lower. However, to the credit of FIT, there has been a decline in volatility inoverall inflation, particularly core inflation.
The key objective of inflation targeting is to anchor inflation expectations. ‘Toanchor’ here means to enable inflation to remain relatively insensitive to incomingdata. For example, if the public experiences a spell of inflation higher than theirlong-run expectation, but their long-run expectation of inflation changes little as aresult, then one could say, inflation expectations are well-anchored.
We observe that inflation expectations of the households have come down post FITadoption, as inflation headed down. This goes to say inflation expectations areadaptive, i.e., they depend on the past inflation behavior. However, despitemoderating, household expectations float at ~500 basis points (bps) above actualinflation. In contrast, the expectations of the professional forecasters are betteraligned to the actual.
The jury is still out on the effectiveness of FIT in India, given that it is a relatively newphenomenon. However, the initial performance does seem to be optimistic as theFIT period coincides with both lower inflation and lower inflation expectations.Also, inflation targets are not cast in stone. Many countries have changed theirinflation targets as the policy framework evolved. For India, the current target isvalid till 2021. If the targeting framework works well for the economy, the bandcould be narrowed; or else, an alternative target (rather than headline inflation)might be explored.