Reserve Bank favours retaining inflation target for next 5 years

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The Centre will review the target band as the term of RBI’s MPC ends on 31 March (Mint)The Centre will review the target band as the term of RBI’s MPC ends on 31 March (Mint) 2 min read . Updated: 27 Feb 2021, 12:30 AM IST Gopika Gopakumar

Under India’s flexible inflation targeting approach, the central bank is expected to work to maintain retail inflation at 4%, with an upper tolerance limit of 6% and a lower limit of 2%

The Reserve Bank of India (RBI) said on Friday it is in favour of retaining the existing inflation target set in 2016 for the next five years, ahead of an upcoming government review.

Under India’s flexible inflation targeting (FIT) approach, the central bank is expected to work to maintain retail inflation at 4%, with an upper tolerance limit of 6% and a lower limit of 2%. The six-member monetary policy committee (MPC) headed by the RBI governor decides on policy rates keeping this target in mind.

Mint reported on 28 January that the government may reset the rate at 5% to provide the central bank more leeway to cut policy rates and support growth in the pandemic-struck economy. “The current numerical framework for defining price stability, i.e., an inflation target of 4% with a +/-2 per cent tolerance band, is appropriate for the next five years," RBI said in its report titled Reviewing the Monetary Policy Framework.

Finance minister Nirmala Sitharaman recently said the government will review the target band as the term of the MPC ends on 31 March. The government will notify the average and the band within which the FIT will operate thereafter.

“It is important to recognize that while setting a single target/tolerance band for the next five years, structural changes that may materialize or the type of shocks that may hit the economy are difficult to anticipate fully. Hence, flexibility must be built into the framework, without undermining the discipline of the inflation target, which has to be forward-looking to ensure that inflation expectations are firmly anchored over the medium term to facilitate decisions on investment, savings and consumption," the report said.

The RBI report also suggested changes in the inflation targeting framework for better transparency, accountability and operational efficiency. This includes modifying the definition of failure from the current three consecutive quarters norm of inflation remaining outside the tolerance band, to four consecutive quarters.

The MPC may also consider providing a more explicit forward guidance on the interest rate path at a future date, as the projection process is strengthened further over time, the report suggested.

Staggering on-boarding of external members on the MPC, having an official communication policy document, and releasing minutes within a week after the policy announcement were among other proposed changes. The report also floated the idea of RBI issuing its own bonds to help soak up foreign inflows into stocks that could threaten financial stability.

“Activation of the standing deposit facility can address the security availability constraint of RBI for undertaking sterilization operations, but market-based sterilization instruments are required to avoid misalignment of the operating target relative to the policy repo rate. Adequate provisions for market stabilization scheme securities in the budget may be necessary to strengthen monetary operations of the RBI," it said.

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