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Genesis of 4% Inflation Target
Context:
As Sanjay Malhotra (RBI Governor) prepares to chair his first Monetary Policy Committee (MPC) meeting from February 5-7, 2025, one of the fundamental questions he may ask is: Why does India have a 4% inflation target? The answer to this lies in a historic document—the Chakravarty Committee Report, which marks its 40th anniversary in 2025.
Birth of the Chakravarty Committee
- In 1982, then RBI Governor Manmohan Singh established a committee under Sukhamoy Chakravarty to review India’s monetary system.
- The objective was to assess the linkages between monetary policy, fiscal policy, and the banking system within the context of India’s planned economy.
- To understand the significance of this committee’s recommendations, it is essential to examine the macroeconomic thought of the era.
Economic Thought Before the 1980s
- Keynesian Economics: Following World War II, Keynesian economics dominated policy thinking worldwide.
- Governments focused on boosting economic growth and reducing unemployment, often tolerating moderate inflation.
- This was based on the Phillips curve, which suggested a trade-off between inflation and unemployment—lowering one could mean slightly increasing the other.
- Opposing Views: However, not all economists agreed with this view. In 1968, Milton Friedman argued that this trade-off was only temporary.
- According to him, allowing higher inflation to reduce unemployment would eventually lead to rising inflation expectations, creating a cycle of persistently high inflation.
- This theory was proven right in the 1970s, when economies worldwide experienced both high inflation and high unemployment, leading to the shift from Keynesianism to Monetarism—the belief that controlling money supply was key to managing inflation.
Key Recommendations of the Chakravarty Committee
Against this backdrop, the Chakravarty Committee (1985) analysed India’s economic structure and made significant observations:
- Rising Government Borrowing and Inflation: The share of the public sector in national savings had increased from 8.5% in the First Five-Year Plan (1951-56) to 23.2% by the Sixth Plan (1980-85).
- Despite this, the government relied on deficit financing, issuing ad hoc Treasury Bills (T-Bills) to the RBI to cover expenditures.
- This led to an increase in money supply, which in turn fueled higher inflation—rising from 4% (1951-1971) to 9% (1971-1985).
- Price Stability as a Key Goal: Given the increasing influence of monetarist policies, the committee recommended that price stability should be a primary objective of monetary policy.
- It suggested an inflation target of 4% per annum for the Wholesale Price Index (WPI).
- Reducing Deficit Financing: The committee linked high inflation to excessive money supply, primarily due to the government’s reliance on deficit financing.
- It recommended that the government finance its spending by mobilising public savings and improving the efficiency of public sector enterprises.
- Interest rates on government borrowing should be market-driven, and an active secondary market for government securities should be developed to reduce reliance on RBI funding.
- Monetary Targeting: The committee advocated that the RBI should adopt monetary targeting, with M3 (broad money supply) as the key variable.
- This approach aimed to control inflation by managing money supply growth.
- Banking System Reforms: The committee noted that after bank nationalisation (1969), geographical expansion of banks had been rapid but at the cost of operational efficiency.
Impact of the Chakravarty Committee and Subsequent Reforms
- The 1991 economic reforms marked a turning point in implementing many of the committee’s recommendations.
- As Finance Minister, Manmohan Singh advanced the reforms he had initiated as RBI Governor.
- Another key reform panel, the M. Narasimham Committee, was constituted to review financial sector reforms.
- Gradually, several key transformations took place:
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- Deregulation of interest rates
- Abolition of deficit financing via ad hoc T-Bills
- Development of a government securities market
- Introduction of the repo rate as a key monetary policy tool
The Shift from Monetary Targeting to Inflation Targeting
- Although the RBI initially adopted monetary targeting, it became less effective over time. This was because:
- Innovations in the financial sector led to the creation of new forms of money, making money supply difficult to measure accurately.
- Global experiences showed that targeting interest rates was more effective in controlling inflation.
- The first successful experiment in inflation targeting was conducted by New Zealand, and this approach gradually spread worldwide.
- India moved to a multiple indicator approach in 1997, before formally adopting inflation targeting in 2016.
- The Urjit Patel Committee (2014) played a crucial role in shaping India’s inflation targeting framework, recommending a 4% inflation target with a +/-2% band—a number first proposed by the Chakravarty Committee four decades ago.
Today’s inflation targeting approach relies on adjusting interest rates, rather than controlling money supply growth.
