4% inflation target appropriate: RBI report
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Maintaining the inflation target at 4 per cent into the medium-term is appropriate, according to the Reserve Bank of India’s Report on Currency and Finance (RCF) for the year 2020-21.
Trend inflation
The aforementioned comment is based on the observed decline in trend inflation since 2014 and a decline in inflation persistence.
This observation is significant as it comes in the backdrop of the upcoming review of the inflation target of 4 per cent, with upper tolerance level of 6 per cent and lower tolerance level of 2 per cent.
“Threshold inflation above which growth is unambiguously impaired ranges between 5 and 6 per cent in India, indicating that an inflation rate of 6 per cent is the appropriate upper tolerance limit for the inflation target.
“On the other hand, 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 will hamper growth, indicating that an inflation rate of 2 per cent is the appropriate lower tolerance bound.” the report said.
Under section 45ZA of the RBI Act1934, the Central Government, in consultation with the RBI, fixed the inflation target/ Flexible Inflation Target (FIT) for the period between August 5, 2016 and March 31, 2021, as 4 per cent, with upper tolerance level of 6 per cent and lower tolerance level of 2 per cent.
“Trend inflation to which actual inflation converges after a shock provides an appropriate benchmark for the inflation target; trend inflation has fallen from above 9 per cent before FIT to a range of 3.8 to 4.3 per cent during FIT, indicating that 4 per cent is the appropriate level of the inflation target for India,” the report emphasised.
Monetary policy
Batting for the continuation of the existing monetary policy framework, the report underscored that the institutional architecture of FIT in India, including the size of the monetary policy committee (MPC) and its composition, the decision-making process, communication practices and accountability mechanisms is in line with international best practices.
However, the definition of the time horizon of failure (defined as three consecutive quarters of average headline inflation overshooting/undershooting the upper and lower tolerance levels around the target), processes of onboarding of MPC members, some aspects of forward guidance and timings relating to release of minutes, shut periods and release of transcripts warrant a review.
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