India adopts flexible inflation targeting

The finance ministry and the Reserve Bank of India (RBI) have agreed to put in place a monetary policy framework to focus on flexible inflation targeting, something the central bank has been pressing for.

The Consumer Price Index (CPI)-based inflation targets — below six per cent by January 2016 and four per cent from 2016-17, with a band of plus/minus two per cent — are in line with the recommendations of a panel headed by RBI Deputy Governor Urjit Patel. The panel was set up to suggest ways to reform India’s monetary policy.
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CPI-based inflation for January 2015 stood at 5.1 per cent.

The new framework makes RBI more accountable, as now, it will have to explain to the government if it fails to meet the inflation targets. Economists say the targets will restrain RBI from taking any aggressive and accommodative monetary policy stance. This will put India on a par with other nations in terms of flexible inflation targeting.

While a part of the framework has come into effect from February 20, when RBI and the finance ministry inked an agreement in this regard, the government will have to amend the RBI Act to constitute a monetary policy committee, which will decide on the central bank’s stance. Though it is yet to be seen who the committee will comprise, the agreement hints it might be headed by the RBI governor and the deputy governor in charge of monetary policy will be the vice-chairman (as recommended by the Patel panel).

“The RBI governor and, in his absence the deputy governor in charge of monetary policy, will determine the policy rate, as well as any other monetary measures to achieve the inflation target,” the agreement says.

The pact, inked by Finance Secretary Rajiv Mehrishi and RBI Governor Raghuram Rajan, says the primary target of monetary policy will be achieving price stability, while keeping in mind the objective of growth. RBI will be considered to have failed in controlling inflation if the rate of price rise, as shown by the CPI, exceeds six per cent for the three consecutive quarters beginning 2015-16. This will also hold true if inflation falls below two per cent for three consecutive quarters beginning 2016-17, the agreement says.

The Patel panel had suggested the monetary policy committee be made accountable for failure to achieve the inflation target.

If the central bank fails to meet the target, it will have to state the reasons for this in a report to the Union government, the

agreement says. The report has to propose remedial actions, too, and RBI will have to give an estimate of the time within which the target will be achieved, the agreement adds.

“The Reserve Bank shall publish the operating targets and establish an operating procedure of monetary policy through which the operating target will be achieved. Any change in the operating target(s) and the operating procedure in response to evolving macro-financial conditions shall also be published,” the agreement says. RBI has to publish a document once every six months, detailing the sources of inflation and forecasts for the period between six and 18 months from the date of the publication of the document.

“This will make RBI more accountable. This is good for accountability, transparency and credibility of monetary policy,” said Rupa Rege Nitsure, group chief economist at L&T Financial Services and part of the Ujit Patel committee.

Sonal Verma, executive director and India economist, Nomura, said with this agreement, the government had formally mandated RBI to move towards flexible inflation targeting, in line with the recommendations of the Patel committee. “We see this as a big positive for the economy, as it institutionalises the monetary policy framework and ensures RBI follows a prudent monetary policy henceforth,” Verma said.