RBI would have to write to the govt explaining the reasons for failing to meet the inflation target. If inflation is above 6% or below 2% for three consecutive quarters, the bank would be seen as having failed
In an overhaul of the monetary policy framework, the Reserve Bank of India and the government signed a pact whereby the RBI would tailor its monetary policy to achieve an inflation rate of 4% with a flexibility band of +/- 2% for the financial year 2016-17 and thereafter. “The RBI will aim to bring inflation below 6% by January 2016,” the government said.
Adopting the recommendations of an internal committee of the RBI, the government has made price stability an overriding priority for the central bank.
Amid concerns that RBI’s powers are being clipped, the government has given the central bank freedom to determine the operating procedures and measures to reach the inflation target. The autonomy of the governor in determining the policy rate has also been kept unchanged.
Arvind Subramanian, chief economist adviser, clarified that the RBI would not be under pressure to act on rates. “The decision to cut or not should be taken based on the underline inflationary pressures and the forecast going forward. I am sure it should be based on a technical assessment of this, not based on whether it will be hauled up or not,” he told FE.
But the RBI would have to write to the government explaining the reasons if it fails to meet its inflation target. If inflation is above 6% or below 2% for three consecutive quarters, the bank would be seen as having failed to meet the target.
“If there are unexpected things (for instance, if crude rises sharply), if targets are not met or overshot or undershot, those are things that can be explained,” Subramanian told FE.
Indeed the push for inflation targeting was from RBI governor Raghuram Rajan who had championed the cause amid chronic high inflation.
Rajan had assumed office as governor in September 2013 when retail inflation was at 9.8%. Inflation has eased ever since to 5.11% in January this year.
In a departure from just inflation forecasts, the RBI began setting inflation targets in 2013 after Rajan assumed office.
Even though the RBI had long argued that subdued inflation is essential for long-term sustainable growth, Rajan had also shown reluctance to cut rates as swiftly as government officials wanted him to.
Central bank watchers and economists said that now the key lies in formulation of the monetary policy committee. The composition of the committee would determine the freedom of the RBI. “We have to discuss it. We have to come to an understanding with all stakeholders. Besides the government and RBI, there are other stakeholders also. Then we will promulgate it,” said Rajiv Mehrishi, economic affairs secretary.
“Looking ahead, the structure of the MPC will also be important to watch as responsibility to the RBI (to meet inflation targets) has to be accompanied by greater independence,” said Sonal Varma, India economist at Nomura Securities.
The Patel committee recommends a five-member panel, that would include two external members nominated by the RBI. However, the Srikrishna commission moots an eight-member panel, the majority of them nominated by the government.
The finance ministry has also said the RBI will have to explain the reasons if it fails to meet the target and detail an action plan along with a timeline of how it would bring inflation on target.
Inflation targeting, originally popular among advanced economies barring the US, has gained currency among emerging markets. The central banks of Brazil and South Africa have adopted official targets.