ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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A Revisit

Understanding Inflation Dynamics in India

The flexible inflation targeting framework was formally adopted by India in 2016 with an amendment to the Reserve Bank of India Act. This paper attempts to throw light on the dynamics of consumer price index headline, core, and food inflation, using a relatively young and atheoretical approach pioneered by Stock and Watson in 2007. The empirical results, indicating that the behaviour of core inflation is different from that of headline and food inflation, have implications for the conduct of monetary policy.

In November 2013, the consumer price index (CPI) (base: 2012) headline inflation reached 11.5% with CPI food inflation touching around 17%. On the other hand, in a span of four years, the corresponding figures in June 2017 were placed at 1.5% and -1.2%, respectively. Core inflation, on the contrary, did not exhibit any significant volatility and broadly remained sticky during the period at around 5%. The pertinent questions in this context are: What explains the behaviour of inflation in the short-run as well as over the longer time horizons? What drives these sharp movements in inflation? Do these fluctuations fundamentally reflect any transitory movements around an unobserved structural trend rate of inflation? Or do these fluctuations mirror any shifts in the trend rate of inflation?

The Reserve Bank of India (RBI) formally adopted the flexible inflation targeting (FIT) framework after amending the RBI Act in May 2016. In the literature, inflation targeting is also known as inflation forecast targeting, as the inflation forecast is the intermediate target for the central banks implementing the inflation targeting framework (Sevensson 1996)The central banks implement inflation targeting by setting the policy rate at such levels, which equates the inflation forecast to the inflation target for a horizon corresponding to the control lag. Viewed from this perspective, the standard operating procedure for the central banks under the inflation targeting framework becomes simple and straightforward: tighten monetary policy if the forecast exceeds the target, and loosen it if the forecast undershoots the target. The policy is appropriate if the forecast equals the target. The stockholders and the public can monitor and assess inflation targeting by following the inflation forecast. Above all, it is transparent and easier for the central banks to communicate with the public (Sevensson 1996). Therefore, inflation forecast has a significant role to play in the inflation targeting framework. Inaccuracy in inflation forecast would potentially result in policy errors with real-life consequences. As can be seen from Figures 1a and 1b (p 43), which are reproduced from RBI’s Monetary Policy Report, October 2017, since April 2014, there have been two systematic deviations of actual inflation from the one-quarter ahead projections.

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Updated On : 9th Jan, 2021

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