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Current inflation target framework 'appropriate' for next 5 years, says RBI

BusinessToday.In     February 26, 2021

The Reserve Bank of India (RBI) in its latest report on Currency and Finance (RCF) for 2020-21 has said the current numerical framework  to define price stability -- an  inflation target of 4 per cent with a +/-2 per cent tolerance band -- is appropriate for the next five years. It also said the focus of flexible inflation targeting (FIT) on price stability augurs well for further liberalisation of the capital account to globalise Indian rupee.

The report "Reviewing the Monetary Policy Framework"  assumes  topical  relevance  in  the  context  of  the  review  of  the  inflation  target  by  March  2021 , against  the  backdrop  of  structural  changes  in  the  macroeconomic and financial landscape, the RBI said.

The  study  period in  this  report  is  from  October  2016  to  March  2020, commencing  with  the  formal  operationalisation  of  the  flexible  inflation  targeting  (FIT)  framework, though it excluded the COVID-19 pandemic time in view of data distortions.

As per the RBI, during the period under review, the headline CPI inflation averaged 3.9 per cent in India  with  a  decline  in  inflation  volatility,  which shows the success  of  FIT  in  terms of its primary mandate.

Also read: Centre, states must cut taxes on fuel, says RBI Governor Shaktikanta Das

The central bank said the 4 per cent inflation benchmark is appropriate for India. "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  3.8-4.3  per  cent  during  FIT,  indicating that 4 per cent is the appropriate level of the inflation target for India," the RBI report said.

As per the apex bank, the threshold  inflation  above  which  growth  is  unambiguously  impaired  ranges  between 5 and 6 per cent in India, which shows an inflation rate of 6 per cent is the  appropriate  upper  tolerance  limit.

On  the  other  hand,  a  lower  bound  above  2  per  cent  can  lead  to  actual  inflation  frequently  dipping  below  the  tolerance  band  and a lower  bound  below  2  per  cent  will  hamper growth. This also shows that an inflation rate of 2 per cent is the appropriate lower tolerance bound.

The RBI also said the institutional architecture of FIT in India, including the size of the monetary policy  committee  (MPC)  and  its  composition,  decision  making, communication practices and accountability mechanisms is in line with international  best  practices.

But, it said there's a need to review the definition  of  the  time  horizon  of  failure,  processes of onboarding of MPC members, some aspects of forward guidance and  timings  relating  to  release  of  minutes,  shut  periods  and  release  of  transcripts.

The RBI said during  the  FIT  period,  monetary  transmission  has  been  full  and  reasonably  swift  across  the  money  market  but  less  than  complete  in  the  bond  markets.

"While  there  has  been  an  improvement  in  transmission  to  lending  and  deposit  rates  of  banks,  external  benchmarks  across  all  categories  of  loans  and  deposits could improve transmission further," it said.

The RBI said in the  conduct  of  monetary  policy  in  an  open  economy  setting,  foreign  exchange  reserves  and  associated  liquidity  management  are the key. So, there is a need to enhance the RBI's sterilisation capacity to deal with surges in capital flows, it said.

Also read: RBI working on digital currency, wants to tap on blockchain technology: Das

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