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Monetary policy framework: Signals so far suggest no change in inflation target

Shishir Sinha New Delhi | Updated on March 28, 2021

India is set to announce new monetary policy framework next week. Most important element of the framework will be inflation target.

Though, officials in the Finance Ministry are tight lipped over inflation target to be proposed in the new framework, but expectation is target inflation will not see any change. The first agreement, signed between Central Government and the Reserve Bank of India On February 20, 2015, had mentioned: “The Reserve Bank will aim to bring inflation below 6 per cent by January 2016. The target of financial year 2016-17 and all subsequent years shall for four (4) per cent with a band of +/- 2 per cent.”

One big indication for no change in the target came from a RBI working paper (Measuring Trend Inflation in India, 2020), authored by its Deputy Governor Michael Debabrata Patra along with Harendra Kumar Behera.

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According to the paper, the decline in trend inflation since 2014 is, however, coincident with a flattening of the Philips curve. Underlying this is (a) a decline in the inflation persistence, indicating that households and businesses in India are becoming more forward-looking than before as credibility associated with monetary policy increases; and (b) an increase in sacrifice ratio – further disinflations will become costlier in terms of the output foregone. At the same time, the credibility bonus accruing to monetary policy warrants smaller policy actions to achieve the target.

“This points to maintaining the inflation target at 4 per cent into the medium-term. If it ain’t broke, don’t fix it,” the paper suggested. It may be noted that Patra is in charge of Monetary Policy Department. Though the paper appeared with a disclaimer that views expressed not necessarily belong to RBI, but even then, there was enough indication about no change in the target.

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In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. It also provides for the inflation target to be set by the Centre in consultation with RBI, once in every five years. This amendment explicitly provides the legislative mandate to the RBI to operate the monetary policy framework of the country for which agreement was signed in February 2015.

Accordingly, the Central Government notified 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. The notification also listed factors that constitute failure to achieve the inflation target. These include the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters, or the average inflation is less than the lower tolerance level for any three consecutive quarters.

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The framework aims at setting the policy rate (repo rate) based on an assessment of the current and evolving macroeconomic situation and modulation of liquidity conditions to anchor money market rates at or around the repo rate. Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth. The operating framework is fine-tuned and revised depending on the evolving financial market and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was last revised significantly in April 2016.

Published on March 27, 2021

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