Assessing Inflation Targeting!
The Context

Over the past three and a half decades since the formal adoption of inflation targeting
(IT), it has proliferated across continents, regardless of the position of host jurisdictions
in the developmental ladder. By the turn of this century, it has been increasingly
embraced by emerging market economies (EMEs) so much so that they now
outnumber advanced economies (AEs) as practitioners. A unique feature of IT is its
operationalisation even before the development of a formal theory?. The journey of IT
has been tumultuous, navigating as it has the Great Moderation and 'once in a century'
shocks such as the global financial crisis (GFC), the COVID-19 pandemic, and
persisting geopolitical conflicts that have had a direct bearing on both inflation's
evolution and on financial conditions. Yet, there is no evidence of any major country
abandoning it?. On the other hand, central banks have drawn lessons from these
humungous challenges and innovated and refined their policy frameworks. The
endogenous evolution of IT has rendered it the longest surviving monetary policy

framework in modern times.

Three pillars of the framework - flexibility; transparency and, therefore,
accountability; and credibility - have enabled IT to stand the test of time. Empirical

evidence suggests that the post-pandemic price shocks have actually had relatively

' Address delivered by Michael Debabrata Patra, Deputy Governor, Reserve Bank of India (RBI) at the
High Level Conference "Central Banking at Crossroads" organised by the Reserve Bank of India as
apart of commemoration of its 90" year on October 14, 2024 at New Delhi, India. Valuable comments
received from Binod B Bhoi, Indranil Bhattacharya, Soumasree Tiwari, and editorial help from Vineet
Kumar Srivastava are gratefully acknowledged.

2 King, Mervyn A. (2024). Inflation Targets: Practice Anead of Theory. NBER Working Paper No. 32594,
June.

3 Argentina moved out of IT in 2018, and it is under an IMF program currently with an ambitious
stabilization plan.

short-lived effects in comparison with the persistence of the price shocks of the 1970s
on the wider acceptance that monetary policy will do whatever it takes*. The
effectiveness of inflation targeting is also found to be underpinned by its institutional
quality,® reinforcing pre-pandemic evidence pointing to IT being a better absorber of
shocks than other regimes.® The taming of the post-pandemic surge in inflation down
to its last lap provides further validation of the framework. Everywhere, long-term

inflation expectations remain broadly anchored' in spite of heightened uncertainty.®
Il. What the Reviews Revealed

Unlike other monetary policy regimes, periodic reviews have been an integral part of
the IT framework, and have, in fact, been hard coded into legislative mandates. While
there have been notable operational similarities in target setting, policy communication
and performance assessment within subtle adaptations to country specific
requirements, there is variation in the way IT frameworks are reviewed.° The latest
reviews of IT frameworks in several countries provide interesting insights about the

future of IT.

The key motivations for these framework reviews were (i) the decline in the neutral

interest rate and the higher risk of hitting the zero lower bound; (ii) the lowering of

4 Bernanke, B. S. and Blanchard, O. (2024). An Analysis of Pandemic-Era Inflation in 11 Economies.
Hutchins Center Working Paper #91, May.

5 Milas, C., Dergiades, T., Panagiotidis, T., and Papapanagiotou, G. (2024). An Assessment of Inflation
Targeting. Quarterly Review of Economics and Finance 97, 101897.

§ Fratzscher, M., Grosse-Steffen, C. and Rieth, M. (2020). Inflation Targeting as a Shock Absorber.
Journal of International Economics 123, 103308.

7 Schnabel, I. (2024). The Future of Inflation (Forecast) Targeting. Keynote speech at the thirteenth
conference organised by the International Research Forum on Monetary Policy, "Monetary Policy
Challenges during Uncertain Times', at the Federal Reserve Board, Washington, D.C. April 17.

§ Lagarde, C. (2022). Monetary Policy in an Uncertain World. Speech delivered at "The ECB and Its
Watchers XXII" conference, Frankfurt am Main, March 17.

° Wadsworth, A. (2017). An International Comparison of Inflation Targeting Frameworks. Reserve Bank
of New Zealand Bulletin, Vol.80, No.8, August.

inflation expectations which further constrained policy space; and (iii) the flattening of

the Phillips Curve giving recoveries 'more room to run'.'°

Overall, the reviews have reaffirmed faith in the broad framework of IT, but with some
refinements. Common outcomes include (i) specification of the target range in terms
of headline inflation with a focus on mid-points; (ii) re-emphasising accountability
criteria for meeting the target over a period rather than at every point in time; (iii)
specifying the periodicity of reviews; and (iv) assessing other measures of inflation -

including core - for policy deliberations but not for specifying the target.

Distinctive outcomes include (i) the US Federal Open Market Committee (FOMC)
defining the target in terms of average inflation of 2 per cent over time; (ii) the ECB
changing the target from "below but close to 2 per cent" to "2 per cent" as a reference
point to ensure that the medium-term inflation rate neither exceeded nor remained
below this symmetric threshold"'; (iii) New Zealand including maximum sustainable
employment as an additional objective effective from 2019 but reverting to solely
targeting price stability in December 2023; (iv) Japan exiting its negative interest rate
policy and discontinuing quantitative and qualitative monetary easing (QQE) along
with yield curve control (YCC) in March 2024"; and (vi) Thailand, Brazil and Indonesia

lowering targets/target ranges.

What the reviews did not reveal is also interesting because of more recent

developments. For instance, even while formal IT frameworks enabled central banks

10 Adrian, T. (2021). Review of Monetary Policy Frameworks. Remarks at Central Banking Magazine's,
Reserve Management Americas Workshop, March 16.

1 Benigno P., Canofari, P., Dibartolomeo, G. and Messori, M. (2021). The Implementation and
Rationale of the ECB's New Inflation Target. Monetary Dialogue Papers, European Parliament,
November.

12 Kazuo, U. (2024). On the Recent Changes in the Bank of Japan's Monetary Policy Framework.
Remarks at the Peterson Institute for International Economics, April 19.

to forcefully respond to both high and low inflation, there is no clear assessment of the
manner and extent to which financial stability considerations should be accounted for
in the pursuit of price stability. In the event, the excesses of 'too low for too long' and
also of 'higher for longer' have been exposed and the absence of a settled position
makes policy responses vulnerable to banking crises of the March 2023 type, the
unwinding of carry trade as in August 2024 and recession fears on a single data
release on September 3, 2024 which left data dependent IT practising central banks
awash in an ocean of uncertainty due to sudden large revisions in market
expectations. Second, the reviews are silent on the effects of putting central bank
balance sheets on the line in the conduct of unconventional monetary policy.
Consequently, the difficulties encountered in too prolonged a normalisation and in the
incurring of financial losses by central banks will stare at the credibility of the
independent conduct of IT-based monetary policy. Third, communication - a much
feted aspect of IT - has run into asymmetry complications underneath the radar of the
reviews. What seemed fashionable and comforting in the context of easing monetary

policy appears confusing and even blasé on the way up.
lll. Innovations

The post-pandemic experience has been similar in some respects across inflation
targeting AEs and EMEs. The fight against the deep contraction and financial stability
risks brought on by the pandemic triggered unprecedentedly forceful responses from
both. Interest rates were taken down to historical lows. Balance sheets of central
banks were expanded to distended dimensions; and communication was reimagined
in an effort to restore petrified confidence. Likewise, the global outbreak of inflation
following the war in Ukraine drew forth from both among the most aggressive

tightening of monetary policy in the history of each once it was realised that the inflation

was pernicious and there to stay. The mornings after were, however, somewhat
different - while AEs faced banking and sovereign debt problems, EMEs had to deal
with spillovers from AEs and wild swings in financial asset prices, especially exchange
rates. These discrete experiences have brought forth innovations in the practice of

inflation targeting that have been conditioned by distinct and different realities.

In the case of AEs, an attractive innovation is the concept of averaging inflation targets
propounded by the US Fed. Scarred by the severe constriction of policy space at the
zero interest rate bound or going even lower, its new make-up strategy allows the Fed
to let inflation run moderately above target following a period when it has persistently
fallen below the target. The promise of higher inflation in the future lowers real interest
rates even when the policy rate is pinned at zero, thus boosting output and inflation

today.

In the case of EMEs, the adoption of IT has undoubtedly strengthened their monetary
policy frameworks as evident in the greater external and financial stability they now
enjoy than in past decades in spite of amplified spillovers from AEs and larger
destabilising effects. This bonus has largely accrued from following assignment rules
committing monetary policy to price stability, while dealing with capital flows and
exchange rate volatility with foreign exchange (FX) interventions and macro prudential
measures. FX Interventions, supported by accumulation of foreign exchange reserves,
have squelched volatility by leaning against the tsunamis unleashed by AE monetary
policies. In a world in which a global financial safety net is non-existent or inadequate,
spillovers are global but financial stability is national. In this environment, the benefits
of this risk minimisation strategy overwhelmingly outweigh costs of holding large

reserves.

Macro prudential policies are designed to address side effects and fallouts that slip
through the cracks of FX interventions. If they are not fully sterilised, fluctuations in
capital flows and exchange rates can cause overheated credit expansions, rising
leverage and amplified financial cycles. Macro prudential measures temper the build-
up of these financial imbalances, enhance resilience in the face of rising stress,

dampen oscillations of financial cycles and reduce the likelihood of financial crises.

Both FX interventions and macro prudential policies are intended as complementary
tools that expand the room for manoeuvre for inflation targeting monetary policy. The
experience of EMEs illustrates how forex interventions and the deployment of
macroprudential tools can help improve the trade-off between price and financial
stability'. In the context of AE and EME inflation targeters, therefore, different strokes

for different folks.
IV. IT - The Indian Experience

India was a relatively late entrant to the IT club"; this enabled cherry picking the best
of country experiences. India's flexible inflation targeting (FIT) framework is centred
around an inflation target set at 4 per cent with a tolerance band of +/- 2 per cent
around it. The target is medium-term in nature, initially set for a five-year period (2016-
21) and renewed by the government for another five years (2021-26). The 'F' in India's
FIT consists of (i) a mandate that accords primacy to price stability while being
cognisant of growth; (ii) an inflation target defined in averages rather than as a point;
(iii) achievement of the target over a period of time rather than continuously; (iv) a

tolerance band to accommodate measurement issues, forecast errors and supply

13 BIS (2024). Monetary Policy in the 21% Century: Lessons Learned and Challenges Ahead. Annual
Economic Report, June 30.

14 The framework was formally adopted in 2016, but the pre-conditions and glidepath were put in
place from February 2015.

shocks; and (v) failure to achieve the target being defined as three consecutive
quarters of deviation of inflation from the tolerance band, rather than every deviation

from the target".

During the pre-pandemic period upto end-2019, inflation was low and stable,
averaging around 4 per cent. With the outbreak of the pandemic and associated
lockdowns, inflation breached the upper tolerance band in many months during 2020-
21 and 2021-22. Following the Russia-Ukraine conflict, inflation again veered away
from its target under the impact of multiple and overlapping food and energy shocks.
By April 2022, it reached a peak of 7.8 per cent. The monetary policy response was
front-loaded with a cumulative hike of 250 bps during May 2022-February 2023. In
July and August 2024, inflation has fallen below the target. It is projected to average

4.5 per cent in 2024-25 before aligning with the target on a durable basis in 2025-26.

The Indian experience is unique in view of the incidence of repetitive shocks to food
and fuel prices, which challenged the conduct of monetary policy. In India, price
stability is a shared responsibility under which the government sets the target, and the
central bank achieves it. This allows monetary-fiscal coordination without posing risks
to financial stability, fiscal consolidation or growth"® - perhaps a template for countries

vulnerable to inflationary pressures emanating from supply shocks.
V. New Vistas

In the years ahead, the conduct of IT-based monetary policy may face even greater

challenges. Central banks face an existential threat to their central mandates from

15 Patra, M. D. (2021): "Monetary Policy: Trial by Pandemic," RBI Bulletin, October.

16 Patra, M.D., and Bhoi, B. B (2024). Quelling the Post-pandemic Inflation Surge: The Indian
Experience. Chapter 10 in the book Monetary Policy Responses to the Post-Pandemic Inflation edited
by Bill English, Kristin Forbes and Angel Ubide, Centre for Economic and Policy Research (CEPR),
February.

climate change through supply shocks such as food and energy shortages and
through a decline in productive capacity which can translate to inflation volatility.
Demand shocks can also arise due to the loss of wealth of firms and households on
account of frequent natural disasters. Physical and transition risks can affect the
balance sheets of financial institutions and banks, limiting the flow of credit to the real
economy. Climate induced uncertainty can make households save more for
precautionary purposes, bringing down the real equilibrium interest rate. There are
also several channels through which climate change can affect monetary
transmission. For instance, depreciation pressures on currencies of countries
frequently affected by climate disasters can cause financial instability, higher import
costs as well as negative terms of trade all of which have implications for the mandate
of inflation targeting central banks. Already, several central banks, including the RBI,
have started taking steps to put in place guardrails, including incentives for bank
lending for green energy sources; measuring and managing climate-related risks,
including through stress testing; developing appropriate ecosystems for green bonds,
collateral policies and green deposits; funds-supplying operations to support financing
for climate change responses; and differentiated reserve requirements. The
consensus is hence coalescing to the position that central banks are uniquely placed
to address climate change. The challenge is to incorporate it into inflation targeting

frameworks.

Innovations in payment systems, fintech, and central bank digital currencies can also
change the nature of policy trade-offs facing IT in the future.'" Digitalisation can

directly lower inflation rates through a decline in the prices of information and

17 Allen, F., Kim, J. H. and Walther, A. (2024). Inflation Targeting and Financial Stability. Paper
presented at the conference on "The Quest for Nominal Stability: Lessons from Three Decades with
Inflation Targeting" held at the Sveriges Riksbank, May 23-24.

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communication technology (ICT)-related goods. Digital technologies can also
influence inflation indirectly through changes in firms' price-setting behaviour and
market dynamics, with competition enabled by e-commerce. Dynamic pricing of goods
and services becomes possible, making prices more responsive to economic changes
by reducing menu costs, improving access to information and enhancing price update
flexibility'®. By reducing price stickiness, these developments can potentially make the
Phillips curve steeper, enhancing the efficacy of monetary policy in securing price
stability'?. On the other hand, algorithmic pricing strategies in the digital realm may
result in prices settling above competitive levels. Additionally, the large initial
investment in digital technologies, coupled with lower scaling costs, can lead to a
higher level of market concentration, higher mark-ups and profit margins, and

consequent inflation pressures.

Digitalisation can improve access to financial services and enhance financial inclusion,
thereby improving the transmission of interest rate-based monetary policy°. Financial
digitalisation tends to amplify the effects of monetary policy by loosening credit

constraints. On the other hand, monetary policy transmission could be dampened if

18 Glocker, C., and Piribauer, P. (2021). Digitalization, Retail Trade and Monetary Policy. Journal of
International Money and Finance, 112, 102340.

19 Ari, M. A., Garcia-Macia, M. D., and Mishra, S. (2023). Has the Phillips Curve Become Steeper? IMF
Working Paper No. 2023/100; Friedrich, C., and Selcuk, P. (2022). The Impact of Globalization and
Digitalization on the Phillips Curve. Bank of Canada Staff Working Paper No. 2022-7.

20 Patra, M.D. (2021). Financial Inclusion Empowers Monetary Policy. Address Delivered in the Project
on Financial Inclusion, a Joint Initiative by the IIMA, IRMA and CIIE organised by the IIM, Anmedabad,
December 24.


digitalisation leads to shifting of credit supply from banks to less-regulated/unregulated

nonbanks" or by offsetting reductions in bank deposits. ?2
To conclude,

While formulating monetary policy, it is considered good housekeeping to evaluate the
balance of risks. From this perspective, IT policy frameworks of the future need to be
more robust, realistic and nimble, while exploiting synergies with prudential, fiscal and
structural policies?? and leveraging on technological transformations. Adaptability and
flexibility built into the framework would ensure that the central bank would be able to
nudge the economy towards desirable societal outcomes. The so-called Darwinian
principle of 'Natural Selection' is not Darwinian at all. It is actually attributable to
Herbert Spencer. In my view, Herbert Spencer best describes the future of IT - the

survival of the fittest.

Thank you

21 Buchak, G., Matvos, G., Piskorski, T., and Seru, A. (2018). FinTech, Regulatory Arbitrage, and the
Rise of Shadow Banks. Journal of Financial Economics, 130(3), 453-483; Elliott, D., Meisenzahl, R.,
Peydro, J.L., and Turner, B. C. (2022). Nonbanks, Banks, and Monetary Policy: US Loan-Level
Evidence since the 1990s. Federal Reserve Bank of Chicago Working Paper, No. WP 2022-27, June;
Chen, K., Ren, J., and Zha, T. (2018). The Nexus of Monetary Policy and Shadow Banking in China.
American Economic Review, 108(12):3891-3936.

22 Xiao, K. (2020). Monetary Transmission Through Shadow Banks. The Review of Financial Studies,
33(6):2379-2420.

23 BIS (2024), op. cit.

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