This is why RBI will get more powerful in deciding inflation targets

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This is why RBI will get more powerful in deciding inflation targets The recent decision by the finance ministry and the Reserve Bank of India (RBI) to adopt flexible inflation targeting is the most significant monetary policy overhaul since the reforms in early nineties. It marks a victory for RBI governor Raghuram Rajan who has argued that inflation has to be subdued for India to achieve sustainable long-term growth. It also points to the fact that taming volatile prices is now a top priority for the government.
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RBI is now expected to aim to have consumer inflation fall below 6% by January 2016. It will be seen as missing the target if inflation is at more than 6% for three consecutive quarters starting in the 2015-16 fiscal year. RBI will then pursue consumer inflation target of 4%, with a band of plus or minus 2% points, from the financial year ending in March 2017. If the target is missed, the bank will have to write to the government to explain the reasons, the steps it plans to take to bring inflation back on target and the time frame within which it will be done.

RBI will also publish its operating targets and an operating procedure for the monetary policy through, which the target will be achieved. Besides, it is required to bring out a document every six months explaining the sources of inflation and a forecast for inflation for the next 6-18 months.

In fact, Rajan informally started inflation targeting at the start of last year after an RBI-commissioned report recommended it without the government's formal approval which marked a clear change in approach from what was followed previously when interest rate policy considered several criteria including stability of the rupee exchange rate, government's borrowing needs and the need to protect exports, besides inflation.

The new monetary policy framework was formed following the recommendations of a committee headed by RBI deputy governor Urjit Patel. Apart from the need for inflation targeting, the panel suggested the formation of a five-member monetary policy committee (MPC) headed by the RBI governor. Of the five members, three were suggested to be from RBI, including the deputy governor and the executive director in-charge of monetary policy.

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While the government said it is committed to amend the RBI Act to enable formation of MPC, consensus regarding the structure of the panel seems to be evading. While the ministry of finance is not known to be happy with a committee with most members from RBI, there is also a proposal to increase the number of members. The Patel Committee’s suggestion to include two external members selected by the chairman of the committee (the RBI governor) and vice-chairman (RBI deputy governor) is also a bone of contention. Yet another view point is that since the government appoints the RBI governor, it should have freedom to name MPC members too.

Also, since all amendments will need to be approved by the Parliament, the expected move to amend the RBI Act to reflect a new mandate for the central bank is likely to take several months.

The RBI governor, who has been advised by bank officials and an external panel of advisers, will now be advised by MPC.

The inflation target of 2-6% is seen as challenging as India was suffering from double-digit inflation as recently as 2013. A rebound of oil or food process can really unsettle expected inflation numbers. Actually, containing volatility will need action from the government as well. But going by the Budget which contained unrealistic revenue targets, was short on structural reforms and delayed fiscal consolidation, one wonder as to the extent of support RBI can expect from the government in meeting its target. But given RBI’s bolstered autonomy following the policy change that makes the central bank accountable for taming inflation, it is to be seen if Rajan would be ready to play second fiddle to the government when it comes to delivering the central bank’s mandate.

Overall, the move is likely to add credibility and predictability of monetary policy decisions. It also enhances the government’s responsibility to uphold maintain fiscal prudence as lapses in terms of spending would add to inflationary pressure.

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With the adoption of the new framework, India also joins countries such as the US, the UK (the European Central Bank and the Federal Reserve use inflation targeting) Brazil, Indonesia and South Africa that follow the inflation target approach.