India overhauls monetary policy using inflation targets

March 02, 2015 02:53 pm | Updated 02:53 pm IST - MUMBAI/NEW DELHI

India's government and central bank have agreed to commit to inflation targeting, in the biggest change to monetary policy since India's economy was opened up more than two decades ago, putting priority on subduing almost chronically volatile prices.

In a document dated February 20 but published on the ministry website on Monday, the two sides set a consumer inflation target of 4 per cent, with a band of plus or minus 2 percentage points, for the financial year ending in March 2017.

Reserve Bank of India Governor Raghuram Rajan has championed the move to inflation targeting, increasingly popular among large emerging markets, and the document shows he has won a commitment from Prime Minister Narendra Modi's 10-month-old government.

Rajan has long argued that inflation has to be subdued for India to achieve sustainable long term growth, but has sometimes encountered impatience among government officials wanting faster reductions in interest rates to boost the economy.

In a break with the RBI's past practice, Rajan first set inflation targets at the start of last year, but those central bank targets did not have the government's formal buy-in.

India has suffered from almost chronic inflation volatility, due in part to its dependence on energy imports and the uncertain impact of monsoon rains on its large farm sector, and the difficulties transporting food items to market because of its poor roads and infrastructure.

Fixing the infrastructure bottlenecks was a major part of a federal budget unveiled by the government on Saturday. The budget had also delayed fiscal consolidation to encourage growth.

Prioritising the fight against inflation using targets marks a radical change.

During the past few decades, interest rate policy has taken into account several other criteria aside from inflation, including a the government's borrowing needs, the health of the banking sector, and at times the stability of the rupee exchange rate.

Rupa Rege Nitsure, group chief economist at L&T Financial Services, who was part of a panel that proposed inflation targeting, said the changed framework for policy-setting 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 is 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 to monetary policy since the big bang reforms of 1991 that saw India open its up economy to foreign investors.

Any amendments will need to be approved by parliament, which finance ministry officials have said they will pursue within months.

Policy Committee Next

The agreement between RBI and the finance ministry formalises what has already been effective RBI policy since a central bank committee unveiled the proposal for inflation targeting in January 2014.

The RBI is widely expected to continue cutting interest rates after lowering the key repo rate by a quarter percentage point to 7.75 per cent on Jan. 15.

Inflation has moderated sharply as oil prices slumped since last year. In January, consumer prices rose an annual 5.11 per cent, well within the target.

Under the document, the RBI will first aim to have consumer inflation fall below 6 per cent by January 2016, in line with objectives already spelt out by the central bank.

The central bank will be deemed to have missed its target if consumer inflation is at more than 6 per cent for three consecutive quarters starting in the 2015/16 fiscal year. It will also need to stay above 2 per cent starting the year after.

If it misses, the bank will have to write to the government to explain the causes, and what steps it intends taking to bring inflation back on target within a given time.

The document shed no light on a proposed monetary policy committee that will form a key plank of reform. Neither the composition of the committee or the timing of its introduction, were mentioned in the paper.

It does, however, make clear the RBI governor will continue to determine rates and any measures needed to hit the inflation target. He is currently informally advised by bank officials and an external panel of advisers.

Inflation targeting, used by the European Central Bank and the Federal Reserve, is also becoming increasingly common among emerging markets, with South Africa and Brazil among the countries that have adopted the practice in the last two decades. Many, including Brazil where inflation remains a major issue, have struggled to hit the official target.

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