17  Inflation targeting is generally characterised by an announced inflation target; an inflation forecast, which facilitates forward looking monetary policy decision making; and a high degree of transparency and accountability. According to Lars Svensson, the Swedish economist who later served as Deputy Governor of the Riksbank, this policy framework encompasses a trinity of a mandate for price stability, independence, and accountability for the central bank, which enables anchoring of inflation expectations effectively. In practice, inflation targeting is flexible rather than strict. According to Svensson, flexible inflation targeting means that monetary policy aims at stabilising both inflation around the inflation target and the real economy, whereas strict inflation targeting aims at stabilising inflation only, with little regard to the stability of the real economy. A strict inflation targeter would be who Mervyn King, the former Governor of Bank of England, called an “inflation nutter”. Most of the central banks do not only aim at stabilising inflation around an inflation target, but also put an effort into stabilising real economic variables. This effort is described by the time 18  horizon in achieving the inflation target, which dampens the adverse impact of policies on the real economy. Therefore, an important feature of flexible inflation targeting is that the inflation rate will be on average at target, but perhaps not every month. A key advantage of inflation targeting is that it is easier for the general public to relate to.

A number of prerequisites for the new framework have already been fulfilled by the Central Bank and the government during the past 19  few years with the view of moving towards flexible inflation targeting in the medium-term. At present, as an interim arrangement, the Central Bank conducts its monetary policy within an enhanced framework with features of both monetary aggregate targeting and flexible inflation targeting frameworks. Under this enhanced monetary policy framework, the Central Bank focuses on stabilising inflation in mid-single digits over the medium-term, while supporting the growth objectives and flexibility in exchange rate management. Although the Central Bank does not announce any monetary targets explicitly, broad money aggregates remain a key indicative intermediate variable to guide the conduct of monetary policy. Moreover, instead of reserve money, the Central Bank currently uses the average weighted call money rate (AWCMR) as its operating target and increasingly relies on its market based policy instruments, namely policy interest rates and OMO. As accurate forecasts of inflation and other key variables are essential for the success of flexible inflation targeting, macroeconomic projection capabilities of the Central Bank are currently being strengthened. As an important step toward building technical infrastructure for the successful implementation of flexible inflation targeting, a Forecasting and Policy Analysis System (FPAS) using short-term forecasting tools and medium-term dynamic stochastic general equilibrium (DSGE) techniques, has been developed by the Central Bank with the assistance of the International Monetary Fund (IMF). This system is currently being integrated into the monetary policy formulation process of the Central Bank.