Context: The Reserve Bank of India (RBI) said the current inflation target of 4 per cent with a +/-2 percent tolerance band is appropriate for the next five years.

  • The RBI released the Report on Currency and Finance (RCF) for the year 2020-21.
  • The country adopted the FIT framework in 2016, and the next review of the inflation target is due before March 31, 2021.
  • The primary focus of FIT on price stability augurs well for further liberalisation of the capital account and eventual internationalisation of the Indian rupee, it said.

Key points:

  • Trend inflation has fallen from above nine per cent before FIT to a range of 3.8-4.3 per cent during FIT.
    • It indicates that 4 per cent is the appropriate level of the inflation target for the country.
    • An inflation rate of 6 percent is the appropriate upper tolerance limit for the inflation target.
    • A lower bound above 2 per cent can lead to actual inflation frequently dipping below the tolerance band while a lower bound below 2 per cent.
    • It will hamper growth.
    • Hence an inflation rate of 2 per cent is the appropriate lower tolerance bound.
  • Monetary transmission has been full and reasonably swift across the money market but less than complete in the bond markets.
    • External benchmarks across all categories of loans and deposits could improve transmission further.
  • In an open economy, foreign exchange reserves and associated liquidity management are key.
    • There is a need to enhance the RBI’s sterilisation capacity to deal with surges in capital flows.

The new monetary framework:

  • An agreement between the RBI and central government in 2015: It explicitly made inflation targeting the objective of the MPC while using the repo rate as the instrument for it.  
  • Target given to MPC: The Reserve Bank of India’s (RBI) MPC was given the target of keeping inflation at 4% +/- 2%. This meant that inflation should be between 2% and 6%. 
  • Contrasting target: It contrasted with the multiple indicator approach that predated this framework where the central bank focused on both growth and price stability.

Procedure of inflation targeting: 

  • Review meeting (every two months): Where MPC discuss the likely inflation and growth estimates over the coming months.
  • Targeting inflation using the policy rate: Based on this review, the MPC targets inflation using the policy rate, or the repo rate. 
    • When inflation is higher: Than the inflation target set by the central bank - then the MPC must increase the repo rate. 
    • When the actual inflation is lower than the target: The MPC could decrease the repo rate. 
  • Anchor: The MPC looks at consumer price inflation (CPI) as the inflation target that it must keep between 2% and 6%.