Inflation targeting in India: determinants & its implications for financial stability

Abstract

Flexible inflation targeting (FIT) was formally adopted as a monetary policy tool by RBI in 2015. This paper first undertakes an academic review of inflation targeting (IT) as a policy tool with its pros and cons, along with rationale put forth by the Urjit Patel committee for its adoption in India. The paper then attempts to draw implications for the current policy framework by studying the historical conduct of the monetary policy. This is done by empirically studying the historical relationship (‘97-‘14) between the RBI’s policy tools (interest rates and CRR) and parameters like inflation, output gap, exchange rate and asset prices using multivariate regression. It has been found that the policy rate and CRR in India responds strongly to inflation while output gap and real effective exchange rate are also found to be statistical significant determinants of interest rate. This highlights the traditional importance of inflation in the monetary policy framework for India and thus finds inflation targeting worth considering as a formal policy tool. Finally, the paper also examines the relationship between financial stability and inflation targeting, which has received increased attention post the financial crisis. Indeed, post-crisis, there has an been increased impetus on central banks worldwide to consider financial stability along with their conventional goals of stabilizing inflation and output gap in the economy. It has been argued qualitatively that using counter-cyclical capital regulations along with support from the monetary policy will help achieve the desired financial stability along with the central banks’ conventional objectives.