4% and Flexible: The Case for Stability in India’s Monetary Policy Framework

 

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.