Monetary policy reform:Govt fixes 4% inflation target for 5yrs

Moving towards a new regime, the government today notified 4 per cent inflation target for the next five years, based on which the new interest rate setting panel would take its monetary policy decisions going forward.
The move, which provides for a margin of plus or minus 2 per cent in this target thus fixing the upper tolerance level at 6 per cent till 2021, is being seen as government putting the seal on outgoing RBI Governor Raghuram Rajan's inflation- first model of monetary policy.
"Fixation of an inflation target while giving due emphasis to the objective of growth and challenges of an increasingly complex economy, is an important monetary policy reform with necessary statutory back-up," a Finance Ministry statement said.

In accordance with a monetary policy framework agreement it had entered into with the Reserve Bank in February last year, government notified consumer price inflation target of 4 per cent for the next five years, with an upper tolerance level of 6 per cent and lower tolerance limit of 2 per cent.
"In view of the powers conferred by Section 45ZA of the RBI Act 1934, the central government, in consultation with the Bank, hereby notifies the inflation target beginning from the date of publication of this notification and ending on the March 31, 2021," said the government notification tabled in the Lok Sabha.

Consumer price index or CPI rose by 5.77 per cent in June, the fastest pace in 22 months and it is expected that the implementation of the new Goods and Services Tax (GST) may push up inflation further.

The statement said if the average inflation is more than the upper tolerance level of 6 per cent, or less than the lower tolerance level of 2 per cent, for any three consecutive quarters, it would mean a failure to achieve the inflation target.
"Where RBI fails to meet the inflation target, in terms of the provisions of RBI Act, it shall set out a report to the central government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken by RBI; and an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions," it added.

Government is in the process of setting up a six-member new interest rate-setting panel that will implement the inflation target. The upcoming policy of the RBI on August 9 will be the last monetary review by Rajan.
The Monetary Policy Committee (MPC) will set interest
rates by majority, with a casting vote for the central bank governor in the event of a tie.
Out of six members of MPC, three will be from RBI -- the Governor, who will be the ex-officio Chairperson, a deputy governor and an executive director.
The other three members will be appointed by the central government, on the recommendations of a search-cum-selection committee, which will be headed by the Cabinet Secretary.

"The search committee is yet to name the three government nominees. It is still in process," a top official said.
The Finance Ministry said that the key advantage of a range around an inflation target is that it allows MPC to recognise the short run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle.
"The range also accommodates data limitations, projection errors, short-run supply gaps and instability in the agriculture production, an important factor for CPI inflation, as food articles have a major weight in the CPI indices.

"It also allows to accommodate unanticipated short-term shocks even while nudging public inflation expectations on the centre of the range, to which the monetary policy will return the economy over the medium term, leading to transparency and predictability," the statement added.
The government and the central bank in February last year had entered into a monetary policy framework agreement, under which RBI would set the policy interest rates and aim to bring inflation below 6 per cent by January 2016 and within 4 per cent with a band of (+/-) 2 per cent for 2016-17 and all subsequent years.
The government had amended the RBI Act through Finance Act 2016 to provide for a Monetary Policy Committee (MPC) with a specific inflation goal, but it did not notify the inflation target.

As per the amendments, "The central government shall, in consultation with the (Reserve) Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years. The central government shall, upon such determination, notify the inflation target in the official gazette."
According to Section 45ZA of RBI Act, the government, in consultation with RBI, has to notify Consumer Price Index- based retail inflation target every five years.