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MUMBAI/NEW DELHI (Reuters) - India has formally adopted inflation targeting, a historic monetary policy overhaul that marks a victory for Reserve Bank of India Governor Raghuram Rajan, as the government makes subduing chronically volatile prices a priority.
In a document dated Feb. 20 but published on the ministry website on Monday, the government and the central bank agreed to set a consumer inflation target of 4 percent, with a band of plus or minus 2 percentage points, from the financial year ending in March 2017.
Rajan, an academic and former International Monetary Fund chief economist who took the reins at the RBI in 2013, has championed the move to inflation targeting, increasingly popular among emerging market economies which typically struggle to contain price rises that hurt their poorest citizens.
Monday's document showed the move - the most significant change in monetary policy since India opened its economy more than two decades ago - had the support of Prime Minister Narendra Modi's government. That will be critical, given India's inflation woes cannot be fixed by monetary policy alone.
"The monetary policy framework is clear: the objective is containing inflation," Finance Secretary Rajiv Mehrishi told reporters in New Delhi.
India has suffered from almost chronic price volatility, due in part to its dependence on energy imports and the uncertain impact of monsoon rains on its large farm sector, as well as the difficulties transporting food items to market because of its poor roads and infrastructure.
The government has also historically borrowed heavily to finance its spending, resulting in high fiscal deficits that also push up inflation.
Fixing the infrastructure bottlenecks was a major part of a federal budget unveiled by the government on Saturday.
In return, however, Finance Minister Arun Jaitley also asked for an additional year to bring down the country's fiscal deficit to its medium-term target of 3 percent of gross domestic product, which it now intends to do by 2017/18.
Rajan has long argued that inflation has to be subdued for India to achieve sustainable long-term growth. In a break with RBI practice, he first set targets at the start of last year after an RBI commissioned report recommended it - without the government's formal buy-in.
In the decades before that, interest rate policy took into account several criteria aside from inflation, including the government's borrowing needs and, at times, the stability of the rupee exchange rate and the need to protect exports.
Rupa Rege Nitsure, group chief economist at L&T Financial Services, who was part of the panel that proposed inflation targeting, said the change marked a "paradigm shift".
"This framework will decrease the uncertainty around the decision-making process and there will be limited possibility of any speculation," she said. "Transparency and predictability in monetary policy decisions are significant progress."
The government will now need to amend the RBI Act to reflect a new mandate for the central bank, ushering in the biggest overhaul of monetary policy since the big bang reforms of 1991 that saw India open its up economy to foreign investors.
Any amendments will need to be approved by parliament, which finance ministry officials have said will come within months.
The RBI is widely expected to continue cutting interest rates after lowering the key repo rate by a quarter of a percentage point to 7.75 percent on Jan. 15.
The RBI governor will continue to determine those rates. He is currently informally advised by bank officials and an external panel of advisers, which may be replaced by a monetary policy committee whose composition is still to be agreed.
Indian inflation has moderated sharply as oil prices slumped since last year. In January, consumer prices rose an annual 5.11 percent, well within the target.
Under the document, the RBI will first aim to have consumer inflation fall below 6 percent by January 2016, in line with objectives already spelt out by the central bank.
The central bank will be deemed to have missed its target if inflation is at more than 6 percent for three consecutive quarters starting in the 2015/16 fiscal year. From the year after, it will also need to stay above 2 percent.
If it misses, the bank will have to write to the government to explain the causes, what steps it intends taking to bring inflation back on target, and within what time frame.
Analysts said the inflation target of 2-6 percent would be challenging in a country that as recently as 2013 was suffering from double-digit inflation - a particular risk if oil or food prices rebound.
Reducing this volatility will need action from the bank but also from the government, which was overwhelmingly elected in May 2014 by pledging significant economic reforms.
Yet the budget - billed as a test of Modi's willingness to reform a $2 trillion economy - delayed fiscal consolidation, was short on structural reforms and contained revenue targets some called unrealistic.
Inflation targeting, used by the European Central Bank and the Federal Reserve, is also becoming increasingly common among emerging markets such as South Africa and Brazil.
But many, including Brazil, have struggled to hit the official target.
Additional reporting by Suvashree Dey Choudhury, Neha Dasgupta, and Swati Bhat; Editing by Simon Cameron-Moore, Clara Ferreira Marques and Nick Macfie