The
Reserve Bank of India (RBI) has set the stage for an important policy review.
As part of its second five-year assessment of India’s monetary policy
framework, the RBI has released a Discussion Paper on inflation targeting. The
outcome of this review, which is expected to guide the government’s decision on the
inflation target for the next five years in March 2026, comes at a time when the
global economy is fraught with uncertainty. From geopolitical tensions and
climate disruptions to supply chain fragilities and technological upheavals,
the challenges are plenty.
At
the heart of the debate is a simple but powerful question: should India
continue with the 4% inflation target, or does the changing environment demand
a rethink? And, more importantly, should the central bank focus more on
headline inflation (the price changes households experience every day) or on
core inflation (which filters out volatile food and fuel prices to reflect
underlying demand pressures)?
FIT
at Work: A Quiet Success Story
Since
2016, India has followed the Flexible Inflation Targeting (FIT) framework,
which sets a target of 4% CPI inflation with a tolerance band of ±2%. The
results have been impressive. Inflation has been lower and more stable compared
to the pre-FIT years, and expectations are better anchored. Markets,
businesses, and households now have a clearer sense of the RBI’s priorities.
Even in the face of extraordinary shocks, viz., the pandemic and the Russia–Ukraine
conflict, the framework held firm.
Of
course, it hasn’t been perfect. Food and fuel prices, beyond the central bank’s
direct control, continue to drive volatility. Headline inflation often
overshoots the band, while core inflation sometimes stays stubbornly high. This
underscores the need for sharper communication from the RBI, making it clear
when deviations are driven by temporary shocks and when they reflect deeper
demand-side pressures.
Headline
vs Core: What Should Matter More?
The
sharpest disagreement lies here. Should India continue targeting headline CPI,
which fully captures the cost of living, or should it move toward core
inflation, which many economists argue better reflects policy-relevant
dynamics?
Globally,
nearly all inflation-targeting central banks use headline inflation, and for
good reason. For ordinary households, particularly the poor, food prices are
the most important factor shaping their perception of inflation. Ignoring food
inflation risks damaging credibility. Yet, relying only on headline numbers can
misguide policy if underlying demand pressures remain unchecked.
The
middle ground seems most pragmatic: keep headline CPI as the formal target, but
integrate core inflation analysis more explicitly into monetary policy
deliberations and forward guidance. This way, the RBI can stay true to its
mandate while also addressing persistent demand-driven inflationary pressures.
Why
4% Still Works
When
India adopted FIT in 2016, the Urjit Patel Committee identified 4% as the
“trend inflation” rate consistent with growth and stability. That still holds.
India’s fast productivity growth, coupled with the Balassa–Samuelson effect,
which naturally leads to higher services inflation in emerging
economies, justifies a higher target than advanced economies, which usually aim
for 2%.
Lowering
the target would mean tighter monetary conditions, which could slow growth
unnecessarily. Raising it would risk unanchoring expectations and eroding
credibility. Holding steady at 4% remains the best course.
The
Band Debate
The
±2% tolerance band has served India reasonably well. Narrowing it to ±1.5%
could improve credibility but would come at the cost of greater growth
volatility. Widening it to ±3% would reduce breaches but weaken accountability.
The balanced approach is to keep the current band while making the 4% midpoint
the clear operational anchor.
Introducing
formal “escape clauses” could also help, allowing temporary deviations during
extraordinary shocks such as pandemics, global oil spikes, or extreme climate
events. What matters most, however, is transparent communication: explaining
why deviations occur and how they will be addressed.
Beyond
Monetary Policy
Inflation
management cannot be the RBI’s job alone. Supply-side measures matter just as
much: strengthening buffer stocks, improving food logistics, diversifying
energy sources, and building climate resilience. Stronger fiscal-monetary
coordination is essential to prevent food and fuel volatility from spilling
over into persistent inflation.
The
Road Ahead
India’s
monetary policy framework has matured since 2016. FIT has delivered stability,
transparency, and credibility. But the world is changing, and refinements are
needed. The path forward seems clear:
1) 1) Retain the 4% target with a ±2% band.
2)
Keep headline CPI as the formal target but
give greater weight to core inflation analysis.
3)
Strengthen RBI’s communication to clearly
distinguish between temporary shocks and structural pressures.
4)
Complement monetary policy with
supply-side interventions.
If India can do this, it will maintain the delicate balance between credibility and flexibility, anchoring inflation expectations without stifling growth. In today’s turbulent global economy, that balance is exactly what India needs.
