H T Parekh finance forum
Inflation Targeting
International Experience and
Prospects for India
The inflation targeting framework has been successfully
implemented in several developed and developing countries.
However, the success of this system requires equal commitment
from the government and the central bank. In the case of India,
targeting inflation is politically sustainable given the overwhelming
preference of the population for lower headline inflation.
KANHAIYA SINGH
A
long list of empirical research
shows that low and stable infla-
tion1 is conducive to economic
growth [see, for example, Mishkin 1997;
Barro 1995; Fischer 1993; Feldstein 1996].
In the case of India, a positive variation
in inflation at any level above 3 per cent
is found to be detrimental to growth
[Singh and Kalirajan 2003]. The negative
aspects of inflation volatility are trans-
mitted through relative price distortions
and loss of credibility of the central bank
and the government in responding to
inflation shocks and thereby inducing
expectations of higher inflation. In this
context, Goodfriend (1995) considers the
underlying mandate of the central bank to
be a level of inflation so low that “the
expected rate of change of the general
level of prices ceases to be a factor in
individual and business decision-making”
[Goodfriend 1995:122]. A consensus is
strongly building towards long-term price
stability (read low and stable inflation) as
the key (or even the only) objective of
monetary policy [BIS 1998].
Transition in Monetary
Policy Framework
In order to achieve the monetary objec-
tives, central banks have attempted in the
past a number of nominal anchors includ-
ing exchange rate, monetary aggre-
gates, and nominal income growth, which
ultimately have led to disappointments in
one way or the other. Financial innova-
tions and velocity instability have made
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money demand growth unpredictable.
Many economies which opted for exchange
rate pegs as the instrument of price sta-
bility, became excessively vulnerable to
large swings in capital flows. Nominal
income targeting could not sustain some
of the theoretical scrutiny (model incon-
sistency) and implementation problems
arose out of lags in information on price
and nominal income as also the effects of
productivity shocks.2
However, of late it appears that the
central banks have finally discovered
their favourite anchor in “forecasted
inflation” under the newfound regime of
“inflation targeting” (IT), even while
some academicians remain sceptical
about the efficacy of this regime. The first
country to adopt IT was New Zealand in
1990 and by the end of 2005, the list of
countries following IT has increased many
fold, which includes several emerging
market economies.
What Is Inflation Targeting?
Inflation targeting involves a public
announcement of a medium-term numerical
target for forecasted inflation that the
central bank is pre-committed to, based
on its own assessment (forecast). How-
ever, in practice the central bank is as-
signed a socially optimal inflation target
by the government to be achieved in the
medium term, while the bank has the free-
dom to choose its instruments. Svensson
(1997) claims inflation forecast to be an
ideal intermediate target as it is by defi-
nition the current variable that is most
correlated with the goal.
Economic and Political Weekly
At the heart of the concept of the inflation
targeting problem [Svensson 1999] is the
following equation:
πt + 2 t − π* = −Φ y∆t +1 t
where, π* is the long-run unconditional
and socially optimal inflation target; y ∆t is
output gap (log actual relative to potential
output); πt = pt – pt–1 is inflation rate; Φ is
a positive parameter which is a function
of the weight on output stabilisation, dis-
count factor of the inter-temporal objec-
tive function and supply function param-
eter of the output gap; and pt is log of price
level. The equation requires selecting the
instrument such that deviation between
the two-year conditional inflation forecast
is Φ times the negative of the one-year
output-gap forecast. The above relation-
ship is derived involving both inflation
and output forecast and it implies: (a) all
else equal, lower the expected inflation,
lower will be the inflation today and
(b) lower the expected inflation the higher
today’s output gap can be without result-
ing in higher inflation today. Thus, it is
better for the central bank to keep expec-
tations of the private sector towards lower
future inflation.
In a strict inflation targeting framework
Φ = 0, which leads to the inflation tar-
geting rule, πt + 2 t = π , and there is no
*
consideration for output stabilisation. On
the other hand, in a more general form,
the policy rule could include other goals
such as exchange rate or interest rate
smoothing.
The process of IT involves the central
bank taking actions whenever the expected
rate of inflation is likely to miss the long-
run target inflation and the intensity of the
action and hence the length of interval
at which the forecast of future inflation
would return to the unconditional long-
run target will depend on the overriding
importance of maintaining inflation over
other goals (determined by Φ). In this
sense, IT is also a flexible policy, com-
patible with monetary policy objectives of
any central bank in general. However,
The H T Parekh Finance Forum is
edited and managed by Errol D’Souza,
Shubhashis Gangopadhyay, Subir Gokarn,
Ajay Shah and Praveen Mohanty.
July 8-15, 2006
most of the successful IT countries prefer forecast must be formed in advance by a policy means one that the public under-
not to emphasise anything other than period at least equal to the lag in monetary stands to be ‘credibly’ committed to low
the performance in achieving inflation transmission. inflation” [Friedman 2002]. In order to
stability around the long-term target in In most cases the inflation targets have acquire credibility, the central bank must
order to keep a “credible commitment to been set by the government either solely enjoy independence to select required
price stability” [Rybinski 2006]. With such or jointly with the central bank [Tuladhar instruments and choose its level of aver-
strong commitment one typical problem 2005] and most monetary authorities sion to inflation. However, the indepen-
raised is about the response of IT during publish inflation reports for public infor- dence of monetary policy is also linked to
supply shocks or recession and liquidity mation, which invariably includes the fiscal dominance, particularly associated
trap [Gramlich 2000]. inflation forecast, reasons for deviations with the developing countries.
With supply shocks, such as in oil prices, if any and the time path to bring back
inflation increases with falling output. Any inflation to the required level. Recently, Assessment of Success of IT
control of inflation, a natural course of the Reserve Bank of New Zealand and
action for an IT country, would further Norgesbank have started publishing inter- With inflation as the target of monetary
reduce output, while restoration of output est rate forecasts also in order to increase policy, several countries have registered
would lead to higher inflation. Similarly, transparency and efficient management of impressive success in reducing inflation or
in the case of a liquidity trap, the IT countries expectations. maintaining it at low levels [Bernanke,
have to raise the inflation target along with The success of inflation targeting also Laubach, Posen and Mishkin 1999;
private sector’s expectation and look hinges on the efficiency of the inflation- Mishkin 1999]. However, Ball and
towards fiscal and other monetary means forecasting model. Forecasting errors Sheridan (2003) argue that the performance
as a contingency plan. Another set of po- associated with model specification, of IT countries is overstated because
tential problems arise due to institutional identification of true shocks, projection of targeters and non-targeters both performed
weaknesses leading to high fiscal and exogenous variables and probability dis- better during the 1990s as compared to the
financial imbalances and exchange rate tribution of inflation are critical. Efficient years before the early 1990s and if the
fluctuations, particularly in a developing forecasting may thus require experiment- targeters seem to have reduced inflation
country, where an IT central bank could ing with structural changes in model and by a greater amount, that is due to the fact
misjudge the actual source of shocks and off-model information. that they had a poorer record earlier.
apply instruments too early or too soon in In the IT framework, the credibility of the The key evidence in favour of the suc-
order to contain inflationary expecta- central bank is a central issue. “In today’s cess of the IT framework lies in the fact
tions. Here again it is important to follow context a ‘credible’ central bank is one that that none of the IT countries have opted
prudential norms and transparency with is believed to be firmly committed to low out of this framework. Rather, more coun-
respect to fiscal management, external ex- inflation. And in parallel, a ‘transparent’ tries are joining the bandwagon and
posure of private and public sector and
financial institutions. Table: Coefficient of Variation of Exchange Rate in US, Japan, India and Selected
In practice, IT has intricate design and Inflation Targeting Countries (up to December 2004)
operational features such as a choice CPI Inflation (Mean) Exchange Rate Variation
between price or inflation as the target, the ITF Date During During First During Full During During First During Full
level of the target, the target band, inflation 3-Year 3-Year Period 3-Year 3-Year Period
before ITF after ITF after ITF before ITF after ITF after ITF
model, time dependence, monetary trans-
mission lag, instrument instability, central Brazil Q2-1999 6.83 6.78 8.34 20.86 17.08 24.28
bank independence, transparency and Chile Q1-1991 19.45 17.69 7.25 11.17 7.81 23.57
South Africa Q1-2000 6.60 7.04 5.51 13.15 20.25 22.70
credibility. Israel Q1-1992 18.64 11.90 2.03 9.07 8.35 19.23
Most of the inflation targeting countries Peru Q1-1994 721.51 15.21 6.49 40.44 6.95 16.67
target underlying (and in many cases Czech Republic Q1-1999 8.84 3.60 2.58 10.00 4.79 16.29
Iceland Q1-2001 3.41 4.36 4.12 8.77 14.18 16.18
headline) a consumer price index-based
New Zealand Q1-1990 9.17 2.57 2.28 5.70 0.07 15.89
inflation level varying between 1-6 per Hungary Q1-2001 11.27 6.41 11.32 12.47 13.33 15.41
cent depending upon their past history and Australia Q4-1994 1.61 2.32 2.68 6.06 6.59 15.21
the target bands vary between 0 and 2.5 Sweden Q1-1995 3.46 0.98 1.16 15.20 7.35 14.76
Switzerland Q1-2000 0.54 1.06 0.92 5.40 8.60 13.78
per cent. No country is reported to target Norway Q1-2001 2.64 1.98 1.82 7.52 12.59 13.67
zero inflation or price level. This means Colombia Q3-1999 17.42 8.14 7.49 21.90 10.57 13.39
bygone is bygone. The target ranges are Mexico Q1-1999 23.56 10.38 7.80 10.86 2.66 8.15
to be achieved within an announced time Poland Q4-1998 16.11 7.77 5.02 12.67 5.99 7.73
Canada Q1-1992 3.14 1.21 1.83 5.78 5.63 7.72
horizon of between one and two years or Korea Q1-1998 4.95 3.09 3.51 30.26 8.28 7.57
more depending upon the level of initial UK Q1 1993 6.02 2.51 2.52 8.25 2.78 6.74
inflation and the acceptable trade-off in Thailand Q2-2000 3.62 1.39 1.72 4.70 3.72 4.73
the short run. US* Q1-1995 2.87 2.50 2.46 2.49 5.04 6.14
India* Q1-1995 9.80 8.87 6.41 9.37 7.71 12.56
The central banks in IT countries use Japan* Q1-1995 1.36 0.70 -0.05 10.48 13.26 10.50
the short-term interest rate as their main
Notes: All variations are reported with respect to US$. In the case of US the variation is reported with
operating instrument. Knowledge about respect to SDR. Chile had crawling peg before 1991. Mexico has oil fund. * Countries are non-
the lags in monetary transmission is criti- inflation targeting framework countries.
cal because the central bank’s inflation Source (basic data): IFS.

Economic and Political Weekly July 8-15, 2006 2959

new features are being added to the infla-
tion report of the IT countries. The table
includes the performance of countries with
a history of high inflation such as Peru,
Brazil, Chile, Mexico, Colombia, Israel
and Poland; all have performed well de-
spite weaknesses in their fiscal and finan-
cial systems.
It appears that the key reason for the
success of the IT framework lies in the very
structure of the framework, which calls for
close coordination between the govern-
ment and the central bank. IT starts with
a contract between the central bank and
the government to reduce inflation as an
overriding objective function of monetary
policy, but in the process it has implicit
guaranteed support from the fiscal authori-
ties because the framework requires the
initiative to start from the government in
the form of a directive to the central bank
or legislation to that effect. Commitment
of fiscal policy to economic reform and
macroeconomic management is critical. In
the case of New Zealand, Mikek (2004)
argues that New Zealand could not have
been successful in inflation targeting
without a shift in the fiscal regime, whereby
debt was kept at a prudent level.
The recent experience of Brazil with IT
is a test case of another such resolve, where
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it is strongly reflected that IT can play a
crucial role in macroeconomic stabilisation
[Minella, Freitas, Goldfajn and Muinhos
2003]. Brazil adopted IT in 1999 with a
multi-year inflation target and met the 1999
and 2000 targets but missed the 2001 target
marginally despite real depreciation during
1999. However, in 2002, the increasing
probability that the left wing candidate,
Luiz Inacio Lula da Silva, would be elected,
led to an acute macroeconomic crisis in
Brazil. The rate of interest on Brazilian
government dollar-denominated debt
increased sharply, reflecting an increase in
the market’s assessment of the probability
of default on the debt. In October 2002,
Lula was indeed elected. The Brazilian
real exchange rate depreciated sharply
against the dollar and inflation rose to 12.5
per cent overshooting the target of 3.5 per
cent set for 2003. The Brazilian central
bank responded in an extremely transpar-
ent and pragmatic manner and for its part,
the government committed itself to a high
primary surplus, a reform of the retirement
system, and a revised inflation target. This
in turn convinced the financial markets to
obtain a better fiscal outlook leading to a
decrease in the perceived probability of
default, a real appreciation, and a decrease
in inflation to 5.5 per cent by the middle
Economic and Political Weekly
Economic and Political Weekly
of 2004 [Mishkin 2004]. Thus simulta-
neous commitments of the central bank
and the government are key to success of
this framework.
If India Were to Adopt IT
After demonstrating considerable interest
in the IT framework during late 1990s, the
Indian monetary authorities appear to have
abandoned this idea for some time. Kannan
(1999) first reviewed the possibility of
inflation targeting in the Indian context
and argued for completing financial sector
reforms before its implementation.
Kannan’s concerns were timely. However,
since then the first phase of financial
reforms are almost complete, Basel-I has
been implemented and the RBI is fast
moving on Basel-II [see, for example,
Reddy 2005]. Automatic monetisation is
abolished and most of the deposits and
lending rates are free. There have been
significant developments in application of
market-oriented policy instruments since
the adoption of full-fledged liquidity adjust-
ment facility. In addition the call money rate
is found to act as a good intermediate target
[Singh and Kalirajan 2006 (forthcoming)],
which could be linked to inflationary
expectations through yield structure of
July 8-15, 2006
July 8-15, 2006
long-term bonds. The macroeconomic per-
formance in terms of both the level of
inflation and level of interest rate have
been stable for some time now. All these
conditions are favourable to an inflation
targeting framework. However, in the light
of the foregoing discussion, there are
several issues that need to be taken care
of before actual IT can be adopted in India
and it is important to address them sooner
rather than later.
(1) Although the policy statements of the
RBI invariably state price stability as its
main monetary policy objective, the same
is not enshrined in law. The preamble of
the Reserve Bank of India describes the
basic functions of the Reserve Bank as:
...to regulate the issue of Bank Notes and
keeping of reserves with a view to securing
monetary stability in India and generally
to operate the currency and credit system of
the country to its advantage. http://rbi.org.in/
scripts/AboutusDisplay.aspx#EP1
The above objective means little to an
IT framework. Therefore, a change in RBI
related laws is essential to make its objec-
tives consistent with modern day practice
of conducting monetary policy.
(2) In the Indian debate, inflation is not
considered entirely a monetary phenom-
enon. It is believed that inflationary
pressure builds up from both the supply
as well as the demand-side. In the IT context
the implications are important as noted in
Chand and Singh (2005). “A more cau-
tious approach to inflation targeting in
the Indian context would rely on both
monetary and fiscal instruments and be
closely coordinated with other instruments
such as government buffer stock and
other supply- side operations. If the
forecast rate of inflation were to exceed the
target rate, both the fiscal deficit and its
monetary financing and the general avail-
ability of credit flows would be reduced,
but without necessarily raising interest
rates. Of course, simply reducing the
monetary financing would not be adequate,
and safeguards will need to be built in so
as to ensure that political expediency
does not lead to a watering down of the
commitment to restraining inflation”
[Chand and Singh 2005].
(3) There has been little liberalisation in
the area of directed credit. Commercial
banks are required to direct 40 per cent
of their commercial advances to the
priority sector. At present the percentage
of directed credit appears to be too high
and needs to be narrowed down to highly
focused areas.
Economic and Political Weekly July 8-15, 2006
(4) With the combined fiscal deficit of
central and state governments remaining
in the range of 8-10 per cent of gross
domestic product (GDP), more than 25 per
cent of the time and demand liability of
the banking sector held in government
securities as SLR and the ratio of gross to
net borrowing of the government resting
above 0.60, the central bank independence
is de facto compromised and therefore, the
role of the government in committing to
the IT framework is no less than that of
the RBI.
(5) Even if it is a long way off from
adopting IT, the RBI should without delay
start publishing a full-fledged inflation
report on the lines of IT countries to bring
in transparency in its operations leading
to a smooth transition.
(6) The government should establish an
inflation committee comprising the mini-
stry of finance, the RBI and academi-
cians,backed by an inflation research
project team under the purview of an infla-
tion committee to prepare an exhaustive
inflation report. EPW
Email:ksingh@ncaer.org
Notes
1 Taking into account the measurement errors,
price stability means an inflation level of the
order of 2-3 per cent.
2 However, in the case of India, McKibbin and
Singh (2003) have shown that nominal income
targeting does better than both monetary
targeting and inflation targeting, while inflation
targeting performs better than monetary
targeting.
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