Government formally inducts inflation targeting with flexible failure interpretation

The government has notified the introduction of Inflation Targeting (IT) monetary policy framework as a macroeconomic policy approach for the conduct of the RBI’s monetary policy.

The fresh element as per the government’s notification is the interpretation of monetary policy failure and the launch time for correction measures. As per the policy, if inflation goes above 6% or goes below 2% for three consecutive quarters, then it will be treated as the failure of the RBI’s monetary policy. Counteractive measures should be initiated in such a scenario.

Already, the government has created a Monetary Policy Committee by inducting three members each from the RBI and the Government. First monetary policy statement under the new arrangement with the administration of MPC will be made by the outgoing Governor Raghuram Rajan in September.

Simply, inflation targeting is a monetary policy implementation guideline (Monetary Policy Framework) that instructs the central bank to fix an inflation target and suggest corrective measures to bring back inflation within the set targets with uni-focussed attention.

The major feature of IT is that central bank has only one target, that is inflation and it has use only one policy variable – the repo rate to manage inflation. IT assumes that other goals set by the central bank are just irritants that disturb the inflation targeting attempt.

The Finance Minister has announced the formal adoption of IT in his budget speech 2016. A new monetary policy recommendatory body within the RBI – the Monetary Policy Committee was also constituted to facilitate the launch of the IT. As a preparatory arrangement, the Government and the RBI had signed a Memoranda of Understanding to implement the IT.

Target level of inflation

 The target level of inflation was set at 4% and most importantly, a 2% band is allowed that permits the RBI to have an upper limit of 6% and lower limit of 2% inflation. This means that the inflation rate should lie within 2 – 6% under the IT.

The latest government stand on IT adoption keeps most of the features of the already declared policy including target, upper and lower limits and the structure of the MPC.