Government sets CPI target, cements Rajan legacy

In a week which saw the far-reaching goods and services tax (GST) getting a big push with the Constitutional Amendment Bill being cleared in the upper House of the parliament, the government took another major step on Friday by notifying a retail inflation target of 4% with a 2% margin on the upper and lower sides for five years till 2021.

What this means is that the monetary policy would attempt to contain the inflation rate within the band of 2% to 6%. The 4% inflation target is in line with the government's agreement with the Reserve Bank of India (RBI).

The move is a confirmation of the inflation-fighting policies championed by Reserve Bank of India governor Raghuram Rajan.

"Now there is a statutory basis for a monetary policy framework and the MPC (monetary policy committee, which is yet to be constituted)," said the finance ministry statement.

This is a breakaway from the past tradition of giving an annual single inflation rate target to a range of rates for a longer period and would bring about some certainty into policy-making of the government.

The government said it had fixed a range of inflation to provide a cushion against uncertainty and unforeseen economic shocks that could occur during the five years.

"The range also accommodates data limitations, projection errors, short-run supply gaps and instability in the agriculture production, an important factor for CPI (consumer price index) inflation, as food articles have a major weight in the CPI indices. 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," stated the ministry in its release.

In recent months, the retail inflation has been inching up with June number coming in at 5.77%. Within that, food inflation was at 7.7%. This has caused some concern among economists but most of them see CPI easing with good monsoons. During the previous government regime, retail inflation had shot up to double digit levels.

Richa Gupta, senior economist, Deloitte India, said while the 4% inflation was aspirational it was achievable and would depend on how well the government managed its supply-side issues.

She was concerned about the base effect wearing off this year. Additionally, she said food inflation, which has been stubbornly high in recent times, needed to be controlled.

"So the government is still trying to control and manage that component (food) of inflation. How well we are able to manage the food inflation and, to a certain extent, inflation on account of services will actually determine whether we are able to overcome the adverse base effect and actually lower the prices to reach this 4% aspirational number," said Gupta.

According to her, crude prices could also be a potential risk to the inflation target. However, since currently crude prices were ruling soft they did not pose much threat.

"On the international front, we are okay on the inflation but it's the domestic inflationary pressure on account of food and services that the government needs to manage," she said.

On how the inflation rate target would impact the economic growth, Gupta said the nominal GDP number could get understated but she doesn't see the real GDP figure getting impacted.

"Nominal GDP will definitely get impacted but the real GDP would not be adversely impacted due to the lower inflation target. In a country like India, inflation is like tax on the poor. So, if food prices come down at the consumer level and services inflation is managed, it would not have an adverse impact on the real GDP growth," she said.

The Deloitte economist felt the five-year period for the inflation target was long and believes there may mid-year review within that duration.

The government has put the responsibility for meeting inflation target with RBI, which would have to submit a report to the government giving reasons for the failure and the remedies thereof.

"Where RBI fails to meet the inflation target, in terms of the provisions of RBI Act, it shall set out a report to the central government stating the reasons for failure to achieve the inflation target; remedial actions proposed to be taken; and an estimate of the time-period within which the inflation target shall be achieved," said the government statement.