Inflation targeting, accountability for failure to achieve the inflation target and adopting the new Consumer Price Index (combined) as a measure of nominal anchor for monetary policy formulation are among the recommendations of the central bank’s committee on strengthening monetary policy framework.
Nominal anchor
The nominal anchor should be defined in terms of headline CPI inflation, which closely reflects the cost of living and influences inflation expectations relative to other available metrics.
The committee, headed by RBI Deputy Governor Urjit Patel, has recommended that the nominal anchor or the target for inflation should be set at 4 per cent with a band of +/- 2 per cent around it.
Inflation target
This inflation target is in view of vulnerability of the Indian economy to supply/external shocks and the relatively large weight of food in CPI; and the need to avoid a deflation bias in the conduct of monetary policy.
The committee suggested that this inflation target should be set in the frame of a two-year horizon that is consistent with the need to balance the output costs of disinflation against the speed of entrenchment of credibility in policy commitment.
In view of the elevated level of current CPI inflation and hardened inflation expectations, supply constraints and weak output performance, the committee said the transition path to the target zone should be graduated.
Transition path
Before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent in the next 12 months, inflation should be brought down from the current level of 10 per cent to 8 per cent over a period.
Further, the inflation should be brought down to 6 per cent over a period not exceeding the next 24-month period.
The committee is also of the view that this transition path should be clearly communicated to the public.
Since food and fuel account for more than 57 per cent of CPI on which the direct influence of monetary policy is limited, the commitment to nominal anchor would need to be demonstrated by timely monetary policy response to risks from second-round effects and inflation expectations in response to shocks to food and fuel.
Institutional requirements
For achieving the inflation target and monetary policy making, the committee recommended that the Central Government needs to ensure that its fiscal deficit as a ratio to GDP is brought down to 3 per cent by 2016-17.
Administered setting of prices, wages and interest rates are significant impediments to monetary policy transmission and achievement of the price stability objective, which require a commitment from the Government towards their elimination.
Accountability
The Monetary Policy Committee, headed by the RBI Governor, will be accountable for failure to establish and achieve the nominal anchor.
Failure is defined as the inability to achieve the inflation target of 4 per cent (+/- 2 per cent) for three successive quarters. Such failure will require the MPC to issue a public statement, signed by each member, stating the reason(s) for failure, remedial actions proposed and the likely period of time over which inflation will return to the centre of the inflation target zone.