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What is inflation targeting by RBI?

Maintaining price stability in the economy is one of the objectives of Reserve Bank of India’s (RBI’s) monetary policy. Why is RBI obligated to manage inflation in the economy? What is the inflation target set for RBI? When can RBI be said to have failed to meet the inflation target? And what if RBI fails to keep the inflation within the set target?

What is the history of monetary policy framework in India?

Earlier, multiple indicator approach was followed by RBI which involved monetary policy decisions based on various indicators like credit, output, inflation, capital flows, etc. However, the multiple indicators approach was criticised of failing to provide a clear target for monetary policy due to a large set of indicators.

In 2014, Expert Committee set up by RBI to revise and strengthen monetary policy framework (Chairman: Dr. Urjit Patel) recommended the inflation targeting. In 2015, RBI signed a Monetary Policy Framework Agreement (MPFA) with the Government of India and took a target to bring down inflation in a sequential manner.

Further in May 2016, with amendment to RBI Act, 1934, flexible inflation targeting (FIT) was adopted by setting a target of 4% CPI-Combined inflation with tolerance band of +/- 2%, while simultaneously focusing on growth.

What amendments were made to RBI Act, 1934 for inflation targeting?

  • In May 2016, the preamble of RBI Act, 1934 was amended to add, “Primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth”. 
  • Further, Chapter IIIF on Monetary Policy was added to RBI Act, 1934, with guidelines on inflation targeting, monetary policy committee, etc.

What is the inflation target for RBI? (Section 45ZA of RBI Act, 1934)

As per RBI Act, 1934, inflation target is to be reviewed by the Government of India (in consultation with RBI) every 5 years. 

On August 5, 2016, the medium-term inflation target was decided as 4% CPI-combined inflation with a tolerance band of +/- 2% for the period up to March 31, 2021.

The inflation target was reviewed in March 2021 and March 2026 and retained for a further 5-year period up to March 31, 2026 and March 31, 2031, respectively.

What is Monetary Policy Committee (MPC)? (Section 45ZB, 45ZC & 45ZI of RBI Act, 1934)

Prior to the setting up of Monetary Policy Committee (MPC), the Technical Advisory Committee (TAC) on monetary policy with experts from the fields of economics and finance would advise RBI on the stance of monetary policy. However, its role was only advisory in nature and final decision would be taken by Governor of RBI.

With the amendment to RBI Act, 1934 in May 2016, MPC was set up to decide on the policy rate (i.e. repo rate) with the objective to keep the inflation within the set target. MPC consists of 6 persons – 

  1. Governor of RBI (chairperson)
  2. Deputy Governor of RBI, in-charge of monetary policy (member)  
  3. One officer of RBI nominated by Central Board (member)  
  4. Three persons appointed by the Central Government (members) – term of 4 years, not eligible for reappointment
The above three members of MPC are appointed by the Central Government on the recommendation of search-cum-selection committee consisting of –
  1. Cabinet secretary (chairperson)
  2. Governor of RBI / his representative Deputy Governor (member)
  3. Secretary, Department of Economic Affairs (member) 
  4. Three experts from field of economics / banking / finance / monetary policy, nominated by the Central Government (members)

MPC meets on bi-monthly basis (i.e. in April, June, August, October, December, February). The MPC’s decision is taken by votes and each member has one vote. In case of equality of votes, Governor can have 2nd / casting vote.

What are the publications relating to monetary policy? (Section 45ZL & 45ZM of RBI Act, 1934)

On the 14th day, after every meeting of the MPC, RBI shall publish minutes of the meeting which shall include –

  1. Resolution adopted by MPC
  2. Vote of each member
  3. Statement of each member on the resolution adopted

RBI shall publish Monetary Policy Report once in every 6 months explaining – 

  1. Sources of inflation
  2. Forecast of inflation for 6-18 months from the publication of the document

When can RBI be said to have failed to achieve the inflation target?

As notified by Central Government, RBI can be said to have failed to achieve the inflation target if the average inflation is –

  • More than 6% for 3 consecutive quarters 
  • Less than 2% for 3 consecutive quarters 

What shall RBI do if it fails to achieve the inflation target? (Section 45ZN of RBI Act, 1934)

If RBI fails to meet the inflation target, it shall report to the Central Government – 

  1. Reasons for the failure
  2. Remedial action proposed to be taken 
  3. Estimated time to achieve the inflation target

Which are the other countries following inflation targeting approach?

New Zealand went for inflation targeting in 1989 for the first time in the world. The other countries who have adopted inflation targeting are Canada, UK, Australia, Brazil, South Africa, Indonesia, USA, Japan, Russia, South Korea, etc. 


References

Reserve Bank of India. (2014, January 10). 'Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework'. Retrieved from https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/ECOMRF210114_F.pdf

Reserve Bank of India. (2018, January 15). 'Functions and Workings of RBI'. Retrieved from https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/RWF15012018_FCD40172EE58946BAA647A765DC942BD5.PDF

Reserve Bank of India. (2021, February 26). 'Chapter I: Flexible Inflation Targeting (FIT) in India'. Retrieved from https://www.rbi.org.in/scripts/PublicationsView.aspx?id=20342

Reserve Bank of India. (2022, August 29). 'The Reserve Bank of India Act, 1934'. Retrieved from https://rbi.org.in/Scripts/OccasionalPublications.aspx?head=Reserve%20Bank%20of%20India%20Act

Reserve Bank of India. (n.d.). 'Monetary Policy - Overview'. Retrieved from https://rbi.org.in/scripts/FS_Overview.aspx?fn=2752


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