Targeting inflation, a welcome move

India has taken a major step towards achieving a stable and predictable inflation regime by adopting a monetary policy framework for inflation targeting. An agreement was signed by the Reserve Bank of India and the government which will obligate the RBI to take steps to ensure that inflation does not move beyond or below a prescribed band. The agreement was reached at the instance of the RBI which has for long advocated the need to manage inflation as the key element of monetary policy. Governor Raghuram Rajan has often made known his view that it is necessary to move from the present system of estimating inflation to actually targeting it. The RBI had set up a committee under deputy governor Urjit Patel to suggest a methodology and mechanism to achieve this end. The framework agreement is based on the committee’s recommendations.

The RBI is committed to bring consumer price index-based inflation below 6 per cent by January next year and to 4 per cent by 2016-17. It is bound by this agreement to keep it within a range of plus or minus 2 per cent in subsequent years. The RBI will be held accountable for this and will be considered to have failed in its prime task if inflation exceeds 6 per cent or falls below 2 per cent for three consecutive quarters. It will have to explain the reasons for its failure and propose remedial measures. It also has to periodically make public what its targets are and how it will achieve them. The advantages of the new system are better accountability of the decision-making authority, greater transparency of methods and higher credibility of decisions. Till now monetary policy decisions were taken within the RBI, in effect by the Governor. Henceforth a committee with the Governor as the chairman and representatives of the RBI and the government and experts in monetary economics as members will take these decisions. This is expected to improve decision-making, but it must be ensured that the external members are truly independent and the RBI will have the upper hand.

The system of inflation targeting prevails in most developed economies. The new system is considered the most important monetary policy reform in many years. But it can work well only if the government supports it because it will have a major say on most of the factors that influence inflation, like fiscal deficit, public spending, salaries and shortage or abundance of goods and services. So the government will have to show as great a sense of responsibility as the RBI is taking upon itself.