Does the 4% inflation target need a reset?

livemint.com:

RBI’s) 4% target was in September 2019. This problem is not unique to India. Other countries are also struggling to bring inflation down to their target levels.

The tenacity of inflation despite more than a year of monetary tightening has led experts to question whether inflation targets need to be raised to better reflect new realities. In the US, for instance, a 3% target instead of the current 2% has been suggested. The same question can be asked about India.

India adopted flexible inflation targeting in 2016, and an inflation target is set every five years. In March 2021, the government retained the target at 4% headline CPI inflation for April 2021-March 2026, with lower and upper tolerance limits of 2% and 6%, respectively. Seeing that inflation has been higher than 6% anyway for more than half the number of months since April 2021, should India adopt a higher official target? This question is best answered by examining the current flexible inflation targeting framework in terms of the target rate, the tolerance band and inflation expectations.

Trend inflation Trend inflation is the rate to which inflation converges in the long term. In theory, it is the inflation consistent with optimal GDP and stable employment rates. RBI studies have shown that India’s trend inflation was around 4% in early 2020.

But the trend changes over time in response to structural changes in the economy, which is why estimating—and re-estimating—trend inflation is key to effective monetary policy. If the inflation target is above trend, monetary policy will turn expansionary, creating inflationary conditions. If the target is set below the trend, monetary conditions may be too tight, restricting growth.