Current inflation target band appropriate for next 5 years: RBI report

With the next review of the flexible inflation target (FIT) framework coming up soon, the Reserve Bank of India (RBI) on Friday said the current inflation target of 4 percent with a +/-2 percent tolerance band is appropriate for the next five years.

The country adopted the FIT framework in 2016, and the next review of the inflation target is due before March 31, 2021.

''The current numerical framework for defining price stability, i.e., an inflation target of 4 percent with a +/-2 percent tolerance band, is appropriate for the next five years,'' the RBI said in the Report on Currency and Finance (RCF) for the year 2020-21.

The RBI said the period of study in this report is from October 2016 to March 2020 commencing with the formal operationalization of the FIT framework in the country but excluding the period of the COVID-19 pandemic in view of data distortions.

The report said trend inflation has fallen from above nine percent before FIT to a range of 3.8-4.3 percent during FIT, indicating that 4 percent is the appropriate level of the inflation target for the country, it said.

The report said an inflation rate of 6 percent is the appropriate upper tolerance limit for the inflation target.

''On the other hand, a lower bound above 2 percent can lead to actual inflation frequently dipping below the tolerance band while a lower bound below 2 percent will hamper growth, indicating that an inflation rate of 2 percent is the appropriate lower tolerance bound,'' it said.

The report said that during the FIT period, monetary transmission has been full and reasonably swift across the money market but less than complete in the bond markets.

''While there has been an improvement in transmission to lending and deposit rates of banks, external benchmarks across all categories of loans and deposits could improve transmission further,'' it said.

In the conduct of the monetary policy in an open economy setting, foreign exchange reserves and associated liquidity management are key, it said adding that there is a need to enhance the RBI's sterilization capacity to deal with surges in capital flows.

The primary focus of FIT on price stability augurs well for further liberalization of the capital account and eventual internationalization of the Indian rupee, it said.