RBI Favours Retaining Inflation Target, Tolerance Band For Next Five Years
The Reserve Bank of India logo is displayed on a gate outside the central bank’s regional headquarters in New Delhi. (Photographer: T. Narayan/Bloomberg)

RBI Favours Retaining Inflation Target, Tolerance Band For Next Five Years

The Reserve Bank of India favours retaining the inflation target and the tolerance band adopted in 2016, citing the long-term trend and global experience.

"The current numerical framework for price stability—an inflation target of 4% with a +/-2% tolerance band—is appropriate for the next five years,” the RBI said in its ‘Report On Currency And Finance’.

According to the report:

  • In the international experience, inflation-targeting emerging market economies have generally lowered their inflation targets and narrowed tolerance bands.
  • During the period under review, headline consumer price index inflation averaged 3.9% in India with a decline in inflation volatility, attesting to the success of a flexible inflation targeting framework in terms of its primary mandate.
  • Trend inflation to which actual inflation converges after a shock provides an appropriate benchmark for the inflation target. Trend inflation has fallen from above 9% before FIT to a range of 3.8–4.3% during FIT, indicating that 4% is the appropriate level of the inflation target for India.
  • Threshold inflation above which growth is unambiguously impaired ranges between 5 and 6% in India, indicating that an inflation rate of 6% is the appropriate upper tolerance limit for the inflation target.
  • A lower bound above 2% can lead to actual inflation frequently dipping below the tolerance band while a lower bound below 2% will hamper growth, indicating that an inflation rate of 2% is the appropriate lower tolerance bound.
  • During the FIT period, monetary transmission has been full and reasonably swift across the money market but less than complete in the bond markets.
  • While there has been an improvement in transmission to lending and deposit rates of banks, external benchmarks across all categories of loans and deposits could improve transmission further.
  • The primary focus of FIT on price stability augurs well for further liberalisation of the capital account and eventual internationalisation of the Indian rupee.

What Needs To Change

In the report, the RBI suggested changes in the inflation targeting framework to improve transparency, accountability and operational efficiency.

The failure of MPC to meet the inflation target should be defined as four quarters of overshooting or undershooting the target compared with the current definition of three quarters, according to the report.

The MPC may 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 RBI said. Global practice suggests staggering tenures and exits of the MPC members, which would require an amendment to the RBI Act.

Shut period for MPC members—a communication blackout to avoid market volatility and weakening of transmission of policy signals—may be changed to seven days prior to the announcement and three days after, against the current seven days prior and after the policy.

According to the report, the three-day shut period after the announcement would help in clear and effective communication of the monetary policy decision by the RBI Governor.

The RBI also suggested that the transcripts of the MPC meetings maybe released in public domain after five to seven years. Currently, the central bank releases only the minutes of the meeting after 15 days of the policy announcement.

Among other changes suggested, the RBI said that a formal policy for MPC members may be designed to clarify the do’s and dont’s of communication. This would include written communication and broad guidance for other forms of communication.

To provide certainty to markets, the policy announcement can be at a time that is fixed (barring exceptional circumstances) and pre-announced, the RBI said.

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