The government is expected to retain the medium term inflation target at 4 per cent, with inflation band at 2-6 per cent, for the next five years. Consultations between the Finance Ministry and the Reserve Bank of India indicate the government will continue to retain the existing inflation band, a senior government official said on Friday.
The RBI has argued for retaining the existing band. “We had sought the RBI’s opinion on the matter. It seems prudent to continue with the existing framework as it has served us well in the last five years,” the official said. While the current medium term inflation target — Agreement on the Monetary Policy Framework — was set in August 2016 for a five-year period ending in March 2021, the pact between the government and the central bank for the next five-year period is expected to be signed soon. This institutional framework was endorsed in the amendment of the RBI Act.
There was a proposal before the government to increase the band from the current level in the wake of the sluggish growth induced by the Covid pandemic. However, the RBI was against relaxing the band to boost the growth, arguing that the inflation targeting will then lose its meaning.
The Monetary Policy Committee (MPC) is expected to rein in the inflation within the band agreed to by the government and the RBI. If the MPC fails to keep inflation in the band for three consecutive quarters, the RBI governor would have to write to Parliament as to why it failed and what corrective action needed to achieve the target. The RBI recently proposed modification in the definition of failure from the current three consecutive quarters norm of inflation remaining outside the tolerance band to four consecutive quarters.
The six-member MPC, headed by the RBI Governor, decides on the monetary policy keeping in mind this inflation target band. Retail inflation had fallen to a 16-month low of 4.06 per cent in January due to the easing of food and vegetable prices.
The inflation targeting agreement, formulated in line with the recommendations of the Urjit Patel committee, is expected to smoothen the monetary policy reviews, providing a predictable policy stance on inflation that will help investors, especially in the debt market. Besides, the large fiscal deficit because of the Centre’s borrowings is likely to impact inflation and bond yields.
The RBI’s report on currency and finance for 2020-21 released on February 26 noted that the current inflation tolerance band should be retained for the next five years. “The international experience suggests that inflation targeting EMEs (emerging market economies) have either lowered their inflation targets or kept their targets unchanged over time. In India, however, the repetitive incidence of supply shocks, still elevated inflation expectations and projection errors necessitate persevering with the current numerical framework for the target and tolerance band for inflation for the next five years,” the report says.
According to the RBI, flexibility must be built into the framework, without undermining the discipline of the inflation target, which has to be forward-looking to ensure that inflation expectations are firmly anchored over the medium term to facilitate decisions on investment, savings and consumption, the RBI said. “It is important to revisit the target periodically, even when a review is not required by statute, because changing underlying structural characteristics of the economy and inflation dynamics can render the target sub-optimal,” the RBI recently said.
The RBI has now proposed to limit the shut period for the MPC to start seven days before policy announcement and end three days after the day policy is announced, staggering onboarding of external members on the MPC, an official communication policy document for the MPC and releasing minutes within a week after the policy announcement and releasing policy at a prefixed and pre-announced time. It has proposed to maintain the transcripts of the MPC meetings and its release with a lag of 5-7 years at a future date and provide a more explicit forward guidance on the interest rate path at a future date, as the projection process is strengthened further over time.
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