October 18, 2012 / 19:13 IST
A Goldman Sachs report today suggested setting a formal 'inflation target' by government for anchoring inflation expectation.
"We believe a formal inflation target for monetary policy has the great advantage of focusing attention on the objective that monetary policy can achieve in the long-run, namely price stability," the report said.
A formal inflation target means the government setting a specific target for the central bank for inflation which has a legislative mandate. Countries like New Zealand follows this kind of price index target.
The Reserve Bank in its annual monetary policy predicts an annual inflation number every year which is not a mandate, as there is no inflation target set by the government.
Due to wild variations in the different set of industry data, the RBI has been revising this target many times in the past. For instance this year, the target has been revised upwards twice from 6.5 per cent from 7.5 per cent. Similar were the experiences of the past two fiscal years, too.
Talking about the rationale behind such approach, the report said it would help a nominal anchor for monetary policy and inflation with increased accountability.
"It would allow the RBI to focus on the key variable that is its mandate to influence and withstand external pressures and influence, especially from the government, on changing its goals," it added.
The RBI, which is slated to announce the second quarter monetary policy on October 30 in the backdrop of renewed spurt in inflation, has been fighting a not-so-successful battle against inflation since October 2010 and had been keeping interest rates very high to rein in the demand.
The central bank missed its annual target by a wide margin in last two years and was forced to revise upwards the target numbers many times.
The report also said the government should be in sync with the 'inflation target' mechanism to set the inflation goal for which the central bank will set the instrument.
Talking about inflation numbers, the report said, "an inflation target of 5 per cent +/- 1 per cent seems most appropriate, given the RBI's objective of bringing inflation down to 5 per cent," it said, adding the role of the government is also critical for achieving the target.
The report also pointed out that RBI has to decide which index to use between WPI and CPI.
"The current measure, the WPI, may be inadequate as it does not include services. The new CPI unveiled at the start of 2012 is the most likely candidate," it said, adding the flaws of CPI have to be resolved for effectiveness.
The report further said RBI would need full operational and institutional independence to achieve its target, without any influence from the government.
Talking about forecasting of inflation, it stressed that the central bank could improve its technical and institutional capacity to model and forecast inflation.
