Inflation Anchoring in India

Dr. Punam Devi; Dr. Anand Dahiya; Anand Dahiya; Annu Dalal

Abstract

Monetary targeting provides a nominal anchor to the economic system. Countries initially used currency pegs as a nominal anchor but faced limitations due to a loss of monetary policy flexibility. Transitioning to flexible exchange rates provided autonomy but required a new anchor. Monetary targeting, linking the money supply to inflation, followed but proved challenging due to changing financial dynamics. As a response, many nations, especially those with flexible rates, embraced inflation targeting. In many developing nations, historical dependence on inflation for growth targets, coupled with issues such as inadequate inflation measurement and an unstable demand function for money, has cast doubt on the success of inflation targeting (IT). The global trend has seen a significant shift from monetary targeting to IT, with New Zealand's success inspiring over 50 countries to adopt it. However, IT may pose serious challenges for countries like India. Factors such as fiscal dominance, a lack of continuous and reliable inflation measurement tools, and the shift from the Wholesale Price Index (WPI) to the Consumer Price Index (CPI) contribute to the complexity. Additionally, supply shocks in the food sector and the existence of the Phillips curve present major challenges for India in effectively implementing inflation targeting. The unique economic conditions and structural challenges of developing nations necessitate careful consideration of the suitability of IT as a monetary policy framework.