All you wanted to know about

Ronald Reagan once said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”

Well, inflation might not be as bloodthirsty as Reagan has described it, but it is certainly hated by all — the common man, the business tycoon, the government and maybe even your pet dog; you might be giving it a less tasty meal due to the soaring cost of pet food.

It therefore comes as no surprise that that the finance ministry and the RBI have entered into an agreement to make the control of inflation the main objective of the central bank’s monetary policy. The term used to describe this intent is “inflation targeting”.

Under inflation targeting, the RBI will fix a band within which inflation (as measured by the consumer price index) will be allowed to move. The central bank should adjust its monetary policy to ensure that inflation remains within this band.

If inflation rises above the band, the central bank will hike rates to rein in demand for money and bring down prices. If inflation declines below the threshold, the central bank will decrease rates to make money cheaper and spur demand.

Now, what is the band that has been fixed? The RBI has to ensure that the year-on-year growth in CPI is 6 per cent by January 2016. From the fiscal year 2016-17, the target CPI inflation will be 4 per cent with a leeway to move 2 per cent on either side. The RBI will have to act when inflation beyond either 2 per cent or 8 per cent. If the CPI lingers beyond either outer limit for more than three consecutive quarters, the RBI would have failed to meet the target.

But the onus for reining in inflation does not lie with the RBI alone. Since the finance ministry and the RBI have jointly agreed to adhere to these targets, the government will also do its bit towards this end by controlling fiscal deficit and not making ad hoc increases to prices of government controlled commodities.

It has been mandated that every six months, the RBI should publish a report explaining the sources of inflation and inflation expectation for the next 6 to 18 months. If the RBI misses its targets, it has to inform the Centre why it missed the targets and the remedial actions it will take. This will make it easier for everyone, including companies, individuals and foreign investors to plan their fund-raising as well as investments.

Why should I care?

You should rejoice that the government and the RBI have joined hands to control, if not vanquish, inflation. If they succeed, it will mean a better lifestyle for you as you can enjoy better purchasing power. You can also plan your finances better, once you know where inflation is likely to be.

Inflation targeting will also make it easier to determine the direction in which interest rates are headed. This can help you decide on asset allocation between equity and debt. You can decide your borrowing strategy based on these targets.

If inflation targeting works, it would be great for consumers and savers. But there are doubts about how effective it will be in India. Given the higher level of poverty, growth can take precedence over inflation control. The higher weight to food prices in the CPI may also make inflation harder to control in India, since these prices are dependent on the monsoon and global trends.

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