India moves towards providing inflation target in monetary policy

India has formally adopted inflation targeting, a historic monetary policy overhaul. The Union government and RBI have agreed to set a consumer inflation target of 4 percent, with a band of plus or minus 2 percentage points, from the financial year ending in March 2017. This is the biggest change to monetary policy since opening up of India’s economy more than two decades ago, by introducing inflation targetting to rein in a long history of volatile price rises.

RBI Governor Raghuram Rajan had championed the move to inflation targeting, increasingly popular among emerging market economies which typically struggle to contain price rises that hurt their poorest citizens.

India has suffered from almost chronic price volatility, due in part to its dependence on energy imports and the uncertain impact of monsoon rains on its large farm sector, as well as the difficulties transporting food items to market because of its poor roads and infrastructure.

The government has also historically borrowed heavily to finance its spending, resulting in high fiscal deficits that also push up inflation.

Rajan had long argued that inflation has to be subdued for India to achieve sustainable long-term growth. In a break with RBI practice, he first set targets at the start of 2014 after an RBI commissioned report recommended it—without the government’s formal buy-in.

In the decades before that, interest rate policy took into account several criteria aside from inflation, including the government’s borrowing needs and, at times, the stability of the rupee exchange rate and the need to protect exports.

The government will now need to amend the RBI Act to reflect a new mandate for the central bank, ushering in the biggest overhaul of monetary policy since the big bang reforms of 1991 that saw India open its up economy to foreign investors.

Analysts said the inflation target of 2-6 percent would be challenging in a country that as recently as 2013 was suffering from double-digit inflation—a particular risk if oil or food prices rebound. Reducing this volatility will need action from RBI, but also from the government.

Inflation targeting, used by the European Central Bank and the Federal Reserve, is also becoming increasingly common among emerging markets such as South Africa and Brazil. But many, including Brazil, have struggled to hit the official target.

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