RBI’s inflation targeting policy helps improve external competitiveness as inflation differentials with trading partners narrow

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MUMBAI: Inflation differentials between India and its major trading partners have declined and stabilised since the adoption of flexible inflation targeting framework indicating strength of India’s external competitiveness, according to research paper by the Reserve Bank economist published in RBI’s latest monthly bulletin. The paper said that price stability should continue to be policy focus to maintain the country’s external competitiveness.

In a study Real effective exchange rate (REER) or inflation adjusted effective exchange rate into nominal exchange rates (NEER) and average relative prices shows that inflation differentials (between India and its major trading partners) have remained broadly stable in recent years, according to a research paper published in the Reserve Bank of India’s latest monthly bulletin. ” This may be attributed to the formal adoption of flexible inflation targeting (FIT) framework by the Reserve Bank in June 2016″. Under FIT, the RBI is mandated to maintain price stability within a target of 4 per cent for CPI headline inflation within a band of +/- 2 per cent, while keeping in mind the objective of growth.

The Reserve Bank revises the real effective exchange rate(REER) nominal effective exchange rate (NEER) structure and the currency basket included in the index at periodic intervals to reflect the country’s evolving foreign trade structure, which is a useful guide for assessing the fair value of the currency and external competitiveness.

While NEER is an index of the weighted average of bilateral exchange rates of home currency vis-à-vis currencies of trading partners, with weights derived from their shares in the trade basket of the home currency. A real effective exchange rate (REER) is the NEER adjusted by relative prices or costs, typically captured in inflation differentials between the home economy and trading partners. Based on the assessment of India’s macroeconomic and external sector performance in a ‘normal’ year, 2015-16 is chosen as the new base year for the NEER/REER indices.

The new REER which includes a basket of 40 currencies of India’s major trading partners with 201516 as base year, on average, was 0.8 per cent above its base year level during 2016-17 to 2019-20, a period coinciding with moderate inflation observed since the adoption of FIT framework. Average CPI-based inflation declined to below 4 per cent during 2017-18 to 2019-20 from more than 8 per cent during 2009-10 to 2015-16. “This implies that the inflation differentials between India and its trading partners were less of a concern for former’s external competitiveness under FIT regime” the paper said.

Going forward, large capital inflows unless fully absorbed through current account deficit and/or mopped up as foreign exchange reserves can cause appreciation of the rupee and potentially undermine the export competitiveness. In such a milieu, focus on price stability under FIT regime should remain a policy priority to offset the erosion in external competitiveness which may emanate from appreciation of the rupee in nominal terms, RBI said.

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