New Delhi: The government on Friday formally backed the inflation strategy of the Reserve Bank of India (RBI) by notifying a retail inflation target of 4% as an anchor for monetary policy.

This is consistent with the agreement reached between the central bank and the government last year.

Not only does the move place the government and RBI on the same page, it also sends out a strong signal of stability with respect to the country’s macroeconomic policies—something that had come into question in recent years.

By adhering to specified fiscal deficit targets in the latest Union budget, the government had already conveyed its intent to conform to fiscal reform. Together with its latest move, it has taken a big step towards restoring the credibility of macroeconomic policy, particularly in the eyes of foreign investors and rating agencies.

It also brings the country one step closer to resetting the monetary policy framework. The process will be complete when the government appoints the members of the monetary policy committee, which will define monetary policy in future.

According to a notification tabled in the Lok Sabha by the National Democratic Alliance (NDA), RBI will look to contain Consumer Price Index (CPI)- based inflation at 4% with an upper and lower tolerance limit of two percentage points till 2021.

With this official notification, India joins advanced and emerging market economies of the world to have an inflation targeting mandate for the central bank. The US Federal Reserve, European Central Bank and Bank of England all have inflation targets, as do the central banks of Thailand, Indonesia and the Philippines.

The inflation target will be revisited once every five years, said the government, terming it an important reform.

“Fixation of an inflation target while giving due emphasis to the objective of growth and challenges of an increasingly complex economy, is an important monetary policy reform with necessary statutory back-up," the government said in a statement on Friday.

Outgoing RBI governor Raghuram Rajan has been the chief advocate of such a move, arguing that India needs to rein in inflation to achieve sustainable growth in the long run.

The notification, laid down by minister of state for finance Arjun Ram Meghwal, also ends speculation that the government may revisit the target to boost growth.

Equity and bond markets had rallied recently on hopes that the government may choose a more accommodative inflation target of 5% with a lower and upper tolerance threshold of 1%, which would suggest that policymakers are comfortable with 5% inflation in the medium term.

On Thursday, the benchmark 10-year government bond yield fell three basis points to 7.168%. Bond yields are close to a three-year low as investors chase higher returns in emerging market assets. A basis point is 0.01%.

Economists said that although the move was surprising, the government’s target reinforces the focus of both fiscal and monetary policy in lowering inflation over the medium term.

“A 4% target is a bit of a surprise because my impression was they would set a target of 6% and they would leave the flexibility of tolerance level to the RBI," said A. Prasanna, chief economist at ICICI Securities Primary Dealership Ltd.

The tolerance range of two percentage points will enable policymakers to reckon with short-term trade-offs between inflation and growth while at the same time ensuring the inflation target is achieved in the long run, said the government.

“The range also accommodates data limitations, projection errors, short-run supply gaps and instability in agriculture production, an important factor for CPI inflation as food articles have a major weight in the CPI indices," said the statement.

“It also allows to accommodate unanticipated short-term shocks even while nudging public inflation expectations on the centre of the range, to which the monetary policy will return the economy over the medium term, leading to transparency and predictability," it added.

Indeed, given the risks from global crude oil prices and the upward pressure the seventh pay commission and the goods and services tax will put on prices, inflation could well firm up in the near term.

Retail inflation rose to 5.7% in June, above the central bank’s March 2017 target of 5%. In its June monetary policy statement, RBI highlighted upside risks to its March target.

“Now that the government has formalized that 4% plus or minus 2% (target), it should give RBI complete operational freedom to reach that target," said Soumya Kanti Ghosh, chief economist at State Bank of India, the country’s largest lender.

The inflation target mandate now requires the central bank to give reasons to the government if average inflation goes over 6% or below 2% for three straight quarters. The statement also added that this report from RBI shall state remedial measures the central bank proposes to take and a likely time frame for bringing inflation back to the target level after these measures are implemented.

The final step in institutionalizing a new monetary policy framework would be setting up of the monetary policy committee.

In June, the government had notified that a six-member monetary policy committee will decide on key policy rates, but it is still in the process of finalizing the members.

The panel will have three members from the central bank, including the governor, who will be the chairperson, deputy governor of RBI and one officer of RBI. The other three members will be appointed by the centre, based on the recommendations of a panel headed by the cabinet secretary, and will be experts in the fields of economics, banking, finance or monetary policy. The RBI governor will get a casting vote in case of a tie.

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