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India Fixes 4% Inflation Target for Next 5 Years
Aug 12, 2016

Ahead of Reserve Bank of India (RBI) Governor Raghuram Rajan’s exit, Government officially notified 4 per cent inflation target with a range of +- 2 per cent for the next five years in consultation with the central bank under the monetary policy framework agreement.

  • Fixation of an inflation target while giving due emphasis to the objective of growth and challenges of an increasingly complex economy, is an important monetary policy reform with necessary statutory back-up.
  • After recent monetary policy review on August 9, the fate of key rates will depend upon the Monetary Policy Committee chaired by the RBI Governor.
  • The Government is committed to structural reforms and other measures mentioned in the Budget. The 4 per cent inflation target has demonstrated the Government’s commitment to undertake reform measures.
  • As per the monetary policy framework agreement it had entered into with the RBI in February last year, the Government notified consumer price inflation target of 4 per cent for the next five years, with an upper tolerance level of 6 per cent and lower tolerance limit of 2 per cent.
  • In view of the powers conferred by Section 45ZA of the RBI Act 1934, the central Government, in consultation with the Bank, notifies the inflation target beginning from the date of publication of this notification and ending on the March 31, 2021.
  • The Consumer Price Index (CPI) rose by 5.77 per cent in June, the fastest pace in 22 months and it is expected that the implementation of the new Goods and Services Tax (GST) may push up inflation further.
  • If the average inflation is more than the upper tolerance level of 6 per cent, or less than the lower tolerance level of 2 per cent, for any three consecutive quarters, it would mean a failure to achieve the inflation target.
  • Where the RBI fails to meet the inflation target, in terms of the provisions of RBI Act, it shall set out a report to the central Government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken by the RBI; and an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.

Monetary Policy Committee (MPC)

  • The Government is in the process of setting up a six-member Monetary Policy Committee (MPC) that will implement the inflation target.
  • The MPC will take over the interest rate decision by majority, with a casting vote for the central bank Governor in the event of a tie.
  • The key advantage of a range around an inflation target is that it allows the MPC to recognise the short run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle.
  • The range also accommodates data limitations, projection errors, short-run supply gaps and instability in the agriculture production, an important factor for CPI inflation, as food articles have a major weight in the CPI indices.
  • It also allows accommodating unanticipated short-term shocks even while nudging public inflation expectations on the centre of the range, to which the monetary policy will return the economy over the medium term, leading to transparency and predictability.

Functions of the MPC

The MPC would be entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level. Under sub-section (1) of section 45ZA of the RBI Act, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in every five years. This target would be notified in the Official Gazette.

In exercise of the powers conferred by section 45ZA of the Reserve Bank of India Act, 1934, the Central Government, in consultation with RBI, has fixed the inflation target for the period beginning from the date of publication of the Gazette Notification (August 5, 2016) and ending on the March 31, 2021, as under:

  • Inflation Target: Four per cent.
  • Upper tolerance level: Six per cent.
  • Lower tolerance level: Two per cent.

The key advantage of a range around a target is that it allows MPC to recognise the short run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle.

It also allows to accommodate unanticipated short-term shocks even while nudging public inflation expectations on the centre of the range, to which the monetary policy will return the economy over the medium term, leading to transparency and predictability.

Further, if the average inflation is more than the upper tolerance level of 4% +2%, that is, 6%, or less than the lower tolerance level of 4% –2%, that is 2%, for any three consecutive quarters, it would mean a failure to achieve the inflation target.

Where RBI fails to meet the inflation target, in terms of the provisions of RBI Act, it shall set out a report to the Central Government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken by RBI; and an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.

Fixation of an inflation target while giving due emphasis to the objective of growth and challenges of an increasingly complex economy, is an important monetary policy reform with necessary statutory back-up.


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