Inflation Targeting In India
Inflation targeting is a monetary policy strategy used by Central Banks for maintaining price level at a certain level or within a range. It indicates the primacy of price stability as the key objective of monetary policy. The argument for price stability stems from the fact that rising prices create uncertainties in decision making, adversely affecting savings and encouraging speculative investments. Inflation targeting brings in more predictability and transparency in deciding monetary policy. If the central banks could ensure price stability, households and companies can plan ahead, negotiating wages on the basis of expecting low and stable inflation. Various advanced economies including United States, Canada and Australia have been using inflation targeting as a strategy in their monetary policy framework. The case for inflation targeting has been made in India as the country has been experiencing a high level of inflation till recently.
The Reserve Bank of India and Government of India signed a Monetary Policy Framework Agreement on 20th February 2015. As per terms of the agreement, the objective of monetary policy framework would be primarily to maintain price stability, while keeping in mind the objective of growth. The monetary policy framework would be operated by the RBI. RBI would aim to contain consumer price inflation within 6 percent by January 2016 and within 4 percent with a band of (+/-) 2 percent for all subsequent years.
The central bank would be seen as failing to meet the targets, if retail inflation is more than 6 per cent for three consecutive quarters from 2015-16 and less than 2 per cent for three consecutive quarters from 2016-17. If this happens, RBI will have to explain the reason for its failure to meet as well as give a timeframe within which it will achieve it. RBI will publish the operating targets as well as operating procedure for the monetary policy though which the target for the monetary policy will be achieved. The RBI will also be required to bring a document every six months to explain the sources of inflation and forecast for inflation for next 6-18 months.
RBI has been using headline CPI (Combined) inflation as the nominal anchor for monetary policy stance from April 2014 onwards.
RBI in its Monetary Policy Report in April 2015 stated that this flexible inflation targeting (FIT) framework greatly enhances the credibility and effectiveness of monetary policy, and particularly, the pursuit of the inflation targets that have been set. The commitment of the Government to this framework enhances credibility significantly since it indicates that the Government will do its part on the fiscal side and on supply constraints to reduce the burden on monetary policy in achieving price stability.
Management of monetary policy and the express objective of inflation targeting has been enshrined as the responsibility of RBI by amending the preamble of the RBI Act, 1934 through the Finance Act 2016 (Chapter XII). Thus, ensuring price stability through inflation targeting is a legal responsibility of RBI since 2016. A new Chapter (Chapter IIIF, Section 45Z) was introduced in the RBI Act, through this Finance Bill, 2016, for detailing the operation of a Monetary Policy Committee (MPC), which would be the institutional arrangement at the disposal of RBI for targeting inflation.
Under Section 45ZA(1) of the RBI Act, 1934, the Central Government determines the inflation target in terms of the Consumer Price Index, once in every five years in consultation with the RBI. This target would be notified in the Official Gazette. Amongst other measures, RBI targets inflation primarily by changing the "Policy Rate” which means the rate for repo-transactions as defined under sub-section (12AB) of section 17 of the RBI Act.
Factors constituting failure to meet inflation target under the MPC Framework was notified on 27 June 2016. In exercise of the powers conferred by section 45ZN of the RBI Act, 1934, the Central Government notified the following as factors that constitute failure to achieve the inflation target, namely:—
(a) the average inflation is more than the upper tolerance level of the inflation target notified under section 45ZA of the RBI Act for any three consecutive quarters; or
(b) the average inflation is less than the lower tolerance level of the inflation target notified under section 45ZA of the RBI Act for any three consecutive quarters.