INFLATION TARGETING FRAMEWORK
1. Context
The Monetary Policy Committee (MPC) has decided to conduct an off-cycle meeting today to discuss the failure to meet the inflation target under Section 45ZN of the Reserve Bank of India Act, 1934.
2. Key Points
- As per the Reserve Bank of India Act (RBI), 1934, MPC is required to meet at least four times each year to discuss the macroeconomic issues in the country and take policy decisions to address those.
- This is the second time MPC has conducted an off-cycle meeting in 2022-23.
- The meeting is scheduled in light of inflation being consistently high for nine consecutive months.
3. Inflation Targeting Framework
- In 2016, Parliament amended the RBI Act of 1934 to change the monetary policy and introduce an inflation-targeting framework.
- This framework prioritises price stability to achieve sustainable GDP growth.
- Price stability allows investors to confidently invest their money in productive activities without worrying about losing value.
- Price stability also maintains the purchasing power of consumers, i.e. the ability to purchase a good (or service) with a given amount of money.
4. Persistently high inflation
As per the new framework, the central government, in consultation with RBI sets
- An inflation target and
- An upper and lower tolerance level for retail inflation.
- The target has been set at 4 per cent with an upper tolerance limit of 6 per cent and a lower tolerance limit of 2 per cent.
- The upper and lower limits indicate that although inflation should be close to 4 per cent, the deviation between these limits is acceptable.
- The target and bands are revised every five years.
- In march 2021, the existing targets were carried forward.
- Retail inflation has been above 6 per cent for the past nine months and it has been above 4 per cent from October 2019 onwards
Figure 1: Consumer price index (year-on-year; in percentage)
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
| If inflation is above or below the prescribed limits for three quarters, RBI must submit a report to the central government explaining why prices have been rising (or falling) persistently, what will be done to correct that and estimated when the target will be achieved. |
- The MPC uses tools such as interest rates to control the level of inflation in the economy.
- One such rate is the policy report rate, which is the rate at which RBI lends money to banks.
- An increase in the policy repo rate makes borrowing money more costly and hence is expected to control inflation by reducing the money supply.
- MPC increased this rate from 4 per cent in April 2022 to 4.4 per cent in May 2022, to 4.9 per cent in June 2022, to 5.4 per cent in August 2022 and 5.9 per cent in September 2022.
5. Breaking down the CPI and WPI
- Consumer Price Index (CPI) measures the general prices of goods and services such as food, clothing and fuel over time.
- Retail inflation is calculated as the change in the CPI over a period of time.
- Goods and services such as petrol, food products, health and education are considered for their calculation, which are assigned different weights.
Table 1: Assigned weights for the calculation of CPI
| Category |
Weight
|
| Food and beverages | 46 per cent |
| Miscellaneous (including petrol and diesel, health and education) | 28 per cent |
| Housing | 10 per cent |
| Clothing and footwear | 7 per cent |
| Fuel and Light | 7 per cent |
| Pan, tobacco and intoxications | 2 per cent |
| Total | 100 per cent |
Sources: MOSPI; PRS.
- Between February 2022 and August 2022, the average annual inflation was 6.9 per cent.
- The rise in prices of subcomponents of the CPI during this period is indicated in Table 2.
Table: 2 The average inflation of some CPI components between February 2022 to August 2022 (in percentage)
| Subcategory of CPI | Average inflation |
| Vegetables | 13.26 per cent |
| Oils and facts | 12. 46 per cent |
| Foot wear | 11.41 per cent |
| Fuel and Light | 9.88 per cent |
| Transport and communication | 7. 74 per cent |
| Cereals and products | 6.05 per cent |
Sources: Database on Indian Economy, RBI; PRS
- CPI is not the only index that measures inflation in an economy.
- The Wholesale Price Index (WPI) measures the wholesale prices of goods.
- A change in wholesale prices reflects wholesale inflation.
- Table 3 indicates the weights assigned to goods for calculating the WPI.
- Manufactured goods include metals, chemicals, food products and textiles.
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Primary articles (23per cent) include food articles and crude petroleum and natural gas.
Fuel and power (12 per cent) mineral oils, electricity and coal.
WPI has remained above 10 per cent from April 2021 onwards.
It reached an all-time high of 17 per cent in May 2022.
This was driven by the inflation in metals, kerosene and petroleum coke, fruits and vegetables and palm oil.
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Table: 3 Assigned weights for the calculation of WPI (in percentage)
| Category | Weight |
| Manufactured products | 64 per cent |
| Primary articles | 23 per cent |
| Fuel and Power | 12 per cent |
| All commodities | 100 per cent |
Sources: Ministry of Commerce and Industry; PRS
6. Reasons for WPI inflation consistently above CPI inflation
- Movements in the WPI have an impact on the CPI.
- For almost a year and a half, CPI inflation has remained below WPI inflation.
- As per the design of the indices, it is expected that CPI would remain above WPI and that any increase in WPI would reflect in the CPI after a time lag.
- This is because retail prices include taxes (as a percentage of price), while wholesale prices do not.
- This is because retail prices include taxes (as a percentage of price), while wholesale prices do not.
- Additionally, some of the goods in WPI act as inputs in the goods considered in CPI.
- An increase in input prices would lead to higher retail prices after a time lag.
Figure 2: Consumer Price Index and Wholesale Price Index
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
7. Composition of indices
- As indicated in Tables 2 and 3, the composition of the two indices varies.
- For instance, prices of manufacture of basic metals, chemicals and machinery grew at an average rate of 13 per cent between February 2021 and September 2022.
- They contribute 7 per cent to the WPI.
- These are input goods for the production of final goods and services such as automobiles, which are included in the CPI.
- The rise in prices of transport vehicles, communication devices, fuel for transport and housing (CPI components) rose by 6 per cent during this period.
- The Ministry of Finance has observed that wholesale prices did not feed into retail prices (from March 2021 onwards) as wholesalers absorbed the rising input costs and did not pass them on to retailers.
- In August 2022, it was noted that as retail prices are rising now, the pass-through may occur.
For Prelims & Mains
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For Prelims: Monetary Policy Committee (MPC), Reserve Bank of India Act (RBI), 1934, Inflation Targeting Framework, Wholesale Price Index (WPI) Consumer Price Index (CPI), For Mains: 1. RBI's monetary policy is based on Inflation Targeting Framework reforms. comment (250 Words)
2. How far do you think Inflation targeting as an approach to monetary policy has yielded its intended results? (250 Words)
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Source: PRS
