The New Monetary Policy Framework: What it Means

The monetary policy framework adopted by India and many other countries is correctly described as ‘flexible inflation targeting’. Most of these countries set not only an inflation target but also provide a range within which it can fluctuate. This flexibility is extremely important because it emphasizes the uncertainties against which central bank have to operate. The range implies two things. First, there can be sudden and unexpected supply shocks. This has special implication for developing economies like India where agriculture is still a significant part of the economy. Advanced countries think mostly in terms of ‘oil’ when they talk about supply shocks. In fact, some countries to avoid the impact of supply shocks look at ‘core’ inflation which excludes oil or any other item that may be subject to supply shocks. But supply shocks do have an effect not only on items directly affected but also on other components in the retail price index. This is particularly true in the case of food inflation in countries like India. On the whole, it is better to deal with headline inflation with a range than excluding certain items. The range also underlies the fact that there is always a lag between monetary policy decisions and the impact on inflation. The range thus provides flexibility in terms of the time required to bring inflation back to the desired level when it deviates. It is for this reason (Bernanke and Mishkin, The Journal of Economic Perspectives 11:97–116, 1997) argue that flexible inflation targeting is not a rule but a framework, a case of ‘constrained discretion’.