Flexible inflation regime supports financial stability

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Flexible Inflation targeting (FIT) is a strategy adopted by the central government to specify an inflation rate and then tweak all the monetary policies to achieve the target. It creates a conducive environment for economic growth.

The central government and RBI decided to keep the inflation target at 4%, with an upper tolerance of 6% and a lower tolerance of 2% for five years from 1st April 2021 till 31st March 2026.

Financial stability need not be an explicit goal as it is taken care of in the RBI’s flexible inflation targeting regime.

The current flexible inflation targeting regime anticipates policy actions that would ensure price stability, keeping in mind growth as the key objective.

With proper coordination between monetary policy and macroprudential policy, the financial stability goals are perfectly met implicitly under the FIT regime without reducing the inflation targeting objective.

Now, the question surfaces: Should financial stability be adopted as an implicit or explicit monetary policy by flexible inflation-targeting central banks.

Empirical data shows that there are only a few inflation-targeting central banks that aim to achieve the target explicitly, however, all have a target to achieve financial stability goal. FIT countries like Japan, South Africa, Brazil, and England aim at Financial Stability as the central bank’s mandate.

Macroprudential policies are financial policies that ensure stability in the financial system to prevent disruptions in credit and financial services in the country. These policies had effectively controlled excessive credit growth during 2004-11. The measures did not adversely impact the financial stability and growth rate objectives.

Economists suggest that monetary policies contain inflation risks, but the macroprudential policy is efficient to maintain financial stability in the country. Since the introduction of macroprudential policy in 2004, it has always complemented and supported the monetary policy. The approach shall continue to maintain financial stability in the country while being mindful of the growth target.

Financial stability is an implicit goal accomplished by proper interaction between the macroprudential and monetary policies under one roof. Setting a financial stability target for monetary policy by considering growth and price could be going back to the earlier multiple indicator outlook that would hurt price stability.

Instead of having a financial stability objective, focus on monetary and macroprudential policy so that stability is ensured indirectly within the inflation targets. Hence it is necessary to continue according to the existing framework.

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