Barely four days before the central bank’s monetary policy update, the Indian government on Friday set an annual inflation target of 4%, plus or minus two percentage points, for the next five years.
The move virtually rules out any immediate interest rate cut by the Reserve Bank of India (RBI) since the retail inflation stands precariously close to the upper tolerance level of 5.77%.
In fact, for rural India, the annual inflation is above 6%.
Retail inflation is however expected to come down in the second half of the current fiscal despite the appointment of a new RBI governor and the formation of the monetary policy committee, which is likely to create space for monetary easing by 25 basis points, said Aditi Nayar, senior economist at domestic rating agency ICRA.
“In view of the powers conferred by Section 45ZA of the RBI Act, 1934, the central government, in consultation with the bank (RBI), hereby notifies the inflation target beginning from the date of publication of this notification and ending on March 31, 2021,” a notification tabled in Lok Sabha said on Friday.
According to an earlier notification, the government stated that the inflation target will be considered a failure if the average inflation is more than the upper limit of 6% or below the lower level of 2% for three consecutive quarters.
If RBI fails to meet the inflation target, it will need to state the reasons for failure to the centre in a report along with the remedial actions proposed to be taken and an estimate of the time-period within which the inflation target shall be achieved, the Finance Bill 2016 stated.
The central government had amended the RBI Act through Finance Act, 2016.  The setting of the inflation target comes under the monetary policy framework agreement between the government and the Reserve Bank of India signed in early 2015. The central government in consultation with RBI will henceforth determine the inflation target in terms of the Consumer Price Index (CPI) inflation or retail inflation, once in every five years.
According to the agreement, RBI will once in every six months publish a document to be called the Monetary Policy Report, explaining the sources of inflation and the forecasts of inflation for the period between next six to eighteen months.  The government has started the process of setting up a Monetary Policy Committee (MPC), which would be mandated to set the interest rate – a practice now being done by the RBI. The central bank will need to provide all information to the members of the Monetary Policy Committee that may be relevant to achieve the inflation target.
Out of the six members of MPC, three members will be from RBI, including the RBI governor who will be the ex-officio chairperson, the deputy governor and one officer of RBI.
The other three members of MPC will be appointed by the Centre, on the recommendations of a search-cum-selection committee. These three members of MPC will be experts in the field of economics or banking or finance or monetary policy and will be appointed for a period of four years and will not be eligible for re-appointment.
The meetings of the MPC shall be held at least four times a year and it shall publicise its decisions after each such meeting.