The Indian rupee's value is set by the market, but the central bank tracks its relative value, known as the real effective exchange rate (REER), as a guidepost. Although the bank does not have a target exchange rate, it does intervene in the market to ease volatility.
Late on Friday, the central bank said in a statement that the consumer price index would now be used to arrive at the rupee's value on a REER basis. That is consistent with its move to make CPI the main inflation gauge, in a shift away from the wholesale price index.
Annual CPI inflation in February was 8.10 percent, compared with 4.68 percent for the WPI. The switch to CPI means the rupee was overvalued by around 4 percent in March, based on what the central bank said was a REER of 104.20. A REER of 100 would mean the currency is fairly valued.
Previously, the rupee was undervalued at a REER of 89.46 in March, based on the WPI inflation benchmark.
The rupee has risen 2.8 percent in 2014. It closed at 60.08 to the dollar on Friday. Rupee appreciation has prompted the central bank to buy dollars in the market, increasing India's foreign exchange reserves by $5 billion in the week ended March 28, the biggest weekly gain in 4 months.
RBI shifts to CPI-based Real Effective Exchange Rate
(PTI) Shifting focus to retail inflation, the Reserve Bank today said it will compute and release Real Effective Exchange Rate (REER) only on the basis of the Consumer Price Index (CPI) as the price index for India from this financial year.
"REER index constructed using a CPI for both India and trade partner countries would ensure a higher degree of comparability of former's international competitiveness vis--vis trading partner countries," the RBI said in a release.
REER indicates movements in exchange rates of the home currency against a basket of currencies of trade partner countries and is considered to be an indicator of international competitiveness.
Since October 2013, the RBI has started providing indicative projections of inflation in terms of the broader CPI-Combined.
"Thus, with greater focus on CPI inflation as primary objective of domestic monetary policy, it is pertinent to have an alternative index of REER based on CPI," RBI said.
Till now, in the case of India, the RBI was providing the REER index using the Wholesale Price Index (WPI) for India and CPI for partner countries.
The RBI today released a monthly series on CPI-based REER for both six-currency and 36-currency baskets for the period April 2004 to March 2014.
It said from this financial year, only the CPI-based REER would be compiled and released.