The government and the Reserve Bank of India (RBI) have agreed to adopt a monetary policy framework, which will make taming inflation the primary priority of the central bank’s policy decisions.
Under the new system, billed as biggest monetary reform measure in a generation, the RBI will set a new retail inflation target of below 6% by January 2016 and 4% by March 2017.
The 4% target will have a band of plus or minus 2 percentage points, according to a document published on the finance ministry’s website on Monday.
The framework also will empower the RBI governor Raghuram Rajan to decide the most appropriate measures needed to achieve that target.
A panel headed by RBI deputy governor Urjit Patel had proposed moving to a medium-term inflation target when setting monetary policy.
This approach has now become standard international practice in many mature economies, such as Britain, where the central bank sets interest rates and other monetary tools, according to an inflation target set by the government.
The RBI uses monetary tools to stymie demand and cool prices. In times of weak growth and low prices, it is usually expected that the central bank will cut interest rates to goad companies to invest, add capacities, hire more, and prompt people to spend on houses, cars and other goods.
The new framework will remove ambiguities in the way RBI takes decisions on interest rates.
"Decisions on whether to cut (interest rate) or not should be taken based on inflationary pressures and forecast going forward ...," chief economic adviser Arvind Subramanian said.
A good central bank will take its decision based on data and outlook," chief economic adviser Arvind Subramanian said.
Finance minister Arun Jaitley, while presenting his first full budget on Saturday, had said that a monetary policy framework would be put in place to keep inflation below 6%.
The policy framework would be to “primarily maintain price stability while keeping in mind the objective of growth.”
The government will amend the RBI Act this year and set up a monetary policy committee headed by the RBI governor, would have eight members. The RBI governor would enjoy a veto power in the new structure.
Retail inflation stood at 5.11% in January.
Every six months, RBI would have to bring out a document explaining the sources of inflation and the forecast for the next six to eight months. It would also have give out a report in case the target is missed for a period of time to the central government.
Finance secretary Rajiv Mehrishi said: “It is not a pass or fail test. It is just that you have to explain why you have been unable to do it”.
Besides maintaining price stability, the RBI has to perform many other critical roles.As the banking regulator and the bankers’ banker it is the main financial sector watchdog. As the currency administrator it prints money, as the custodian of foreign exchange reserves it is responsible for preventing volatility in currency markets.