New Delhi/Mumbai: India has set a target for inflation in a landmark change in its monetary policy, a year after the Reserve Bank of India (RBI) informally adopted an inflation target.

The move, strongly championed by RBI governor Raghuram Rajan, is expected to make the monetary policy more predictable.

RBI will look to contain consumer price inflation within 6% by January 2016 and within 4% with a band of 2 percentage points for all subsequent years, as per the monetary policy framework agreement between the central bank and the Union government signed on 20 February, but published on the finance ministry’s website on Monday.

“It is essential to have a modern monetary policy framework to meet the challenge of an increasingly complex economy," the agreement said, adding that the objective of the monetary policy is to primarily maintain price stability while keeping in mind the objective of growth.

“The monetary policy framework is clear: the objective is containing inflation," finance secretary Rajiv Mehrishi told reporters in New Delhi.

The agreement is seen by analysts as proof that the Narendra Modi-led government has bought into Rajan’s suggestion.

Rajan has long argued that inflation has to be subdued for India to achieve sustainable long-term growth. In a break from RBI practice, he first set targets at the start of last year after an RBI-mandated committee headed by deputy governor Urjit Patel recommended it— without the government’s formal buy-in.

Rupa Rege Nitsure, group chief economist at L&T Financial Services, who was part of the panel that proposed inflation targeting, said the change marked a “paradigm shift".

“This framework will decrease the uncertainty around the decision-making process and there will be limited possibility of any speculation," she said. “Transparency and predictability in monetary policy decisions are significant progress."

The government will now need to amend the RBI Act to reflect a new mandate for the central bank, ushering in the biggest overhaul of monetary policy since the big bang reforms of 1991 that saw India open up its economy to foreign investors.

Any amendments will need to be approved by Parliament, which finance ministry officials have said will come within months.

The central bank would be seen as failing to meet the target if retail inflation is more than 6% for three consecutive quarters from the next financial year and less than 2% for three consecutive quarters from 2016-17.

In this case, the central bank will have to explain the reasons for its failure to meet the target as well as give a time frame within which it will achieve it.

RBI will publish the operating targets, as well as an operating procedure for the monetary policy through which the target will be achieved.

The central bank will be 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.

“The move is expected to add to the credibility and predictability of monetary policy decisions. The adoption of the new framework also increases the responsibility of the government to maintain fiscal prudence as fiscal slippage especially on account of higher unproductive spending would be inflationary," said Yes Bank Ltd in a note on Monday.

In response to a question on whether making RBI answerable for the failure to meet the inflation target will discourage it to aggressively cut interest rates, Arvind Subramanian, the chief economic adviser in the finance ministry, said a good central bank will base these decisions on data and inflation outlook. “Decisions whether to cut interest rates or not should be based on underlying inflationary pressure and the forecast going forward. So it should be based on a technical assessment, not based on whether you will be hauled up or not hauled up. I don’t think this should have any necessary impact," he added.

Indeed, the formalization of the target reduces the risk that future policymakers will abandon the overhaul in a nation that last year saw Asia’s highest inflation rate. Rajan had informally adopted an inflation target after taking over the central bank in September 2013.

“There was a lot of speculation whether the RBI has been pressured by the government to lower interest rates," said Madan Sabnavis, chief economist at CARE Ratings in Mumbai. “I think that kind of speculation has been put to rest."

Finance minister Arun Jaitley announced the agreement for a monetary policy framework in his budget on Saturday.

With the adoption of a formal inflation-targeting framework, India joins countries such as the US, UK, Brazil, Indonesia and South Africa that have a formal inflation target.

The report had suggested that RBI should move to a flexible inflation-targeting regime with an aim to bring inflation down to 4% (+/-2%) band. The preconditions for this included the government achieving a fiscal deficit target of 3% by 2016-17, said the report.

Some experts, however, point out that the ability of monetary policy to influence inflation is limited.

“Over the years, I have become less of a believer in the ability of monetary policymakers to influence inflation. In my view, among the principal factors driving inflation are food and fuel prices, none of which are susceptible to monetary policy," said A.V Rajwade, risk management consultant and Mint columnist, adding that demographics is another important factor which influences inflation and has been ignored by policymakers.

Rajwade claims the recent decline seen in inflation seen in India has had little to do with monetary policy. Consumer price inflation in India has fallen from a high of 11% in November 2014 to 5.1% in January. In response to the falling inflation, RBI cut its benchmark policy rate by 25 basis points to 7.75% in January from 8% earlier. Most analysts expect further rate cuts of 50-75 basis points in 2015. A basis point is one hundredth of a percentage point

Yes Bank expects RBI to be able to meet the 6% inflation target for fiscal 2016, with consumer price inflation expected to average about 5.5%, assuming an average oil price of $65/barrel.

While the current environment, with low fuel and food prices, makes it comfortable for RBI to meet inflation targets set under the new framework, any spike in such commodity prices down the road could put the central bank in a tough spot.

According to Rajwade, a more appropriate framework would have been one where along with an inflation mandate, the central bank also has the responsibility of growth and employment.

The US Federal Reserve, for instance, has both a price stability and an employment mandate.

“The government has done a lot of things RBI has asked for," said Edward Teather, senior economist for UBS Group AG in Singapore. “They’re playing ball with RBI—that will help in the broader context of getting Rajan to cut rates."

India’s monetary authority isn’t formally independent. The Reserve Bank of India Act,1934, says the governor will be appointed by the prime minister and allows the federal government to direct the central bank on what it considers public interest.

Bloomberg contributed to this story.

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