In 2016, India had adopted an inflation target of 4 percent for five years to primarily maintain price stability, while keeping in mind the objective of growth. The Reserve Bank of India Act provides for the inflation target to be set by the Government of India, in consultation with the central bank, once in every five years.

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As per the agreement, the central government had notified 4 percent consumer price index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.

However, for December, the retail inflation rose to about five-and-half year high of 7.35 percent, surpassing the RBI's limit of 6 percent mainly due to rising vegetable prices and increasing service costs led by telecom tariff hikes.

So, in case of inflation breaching the set limit, what does the RBI policy framework say?

When the RBI fails to meet the inflation target, it will send a report to the central government stating reasons and the remedial actions that will be taken. A breach of the tolerance level for three consecutive quarters will constitute a failure of monetary policy.

"The central government notified the following as factors that constitute failure to achieve the inflation target: (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters, or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters," the framework stated.

The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.

Repo rate changes transmit through the money market to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth, the framework noted.

Once the repo rate is announced, the operating framework designed by the RBI envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate, it added.

In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation-targeting framework. Prior to the amendment to the RBI Act in May 2016, the flexible inflation targeting framework was governed by an agreement on Monetary Policy Framework between the government and the RBI signed on February 20, 2015.