Indian Monetary Crossroads, The Imperative for a Nuanced Inflation Targeting Framework

Indian Monetary Crossroads, The Imperative for a Nuanced Inflation Targeting Framework

The monetary policy framework of a nation is not merely a technical blueprint for setting interest rates; it is the bedrock of its economic stability, a signal to global investors, and a crucial determinant of the welfare of its citizens. In India, this framework, known as Flexible Inflation Targeting (FIT), is currently under a vital and timely review. Initiated by the Reserve Bank of India (RBI) through a discussion paper, this review has sparked a crucial debate on the future of India’s fight against inflation and its pursuit of growth. The discourse, enriched by insights from eminent economists like Ashima Goyal, a former member of the Monetary Policy Committee (MPC), suggests that the path forward is not about discarding the existing regime but about intelligently fine-tuning it to suit India’s unique and dynamic economic landscape.

The current FIT framework, formally adopted in 2016, mandates the RBI to maintain Consumer Price Index (CPI) inflation at 4%, with a tolerance band of +/- 2 percentage points. This framework was instituted after a prolonged period of high and volatile inflation, particularly in the early 2010s. The evidence of its success in taming the inflation beast is compelling. As Goyal points out, in the pre-FIT period stretching from the 1970s onwards, headline CPI inflation averaged 8.5%. In the post-FIT period, from 2014-15 onwards, this average has dropped significantly to 5%. This is not just a statistical victory; it translates into tangible benefits for the economy. Lower and more stable inflation has helped reduce borrowing costs, narrow risk premiums, and foster a more predictable environment for investment and long-term planning.

However, a deeper dive into the data reveals a more complex story—one that necessitates a nuanced adjustment rather than a triumphant conclusion. The data indicates that since the 1970s, periods of relatively lower growth have coincided with real interest rates (nominal policy rate minus inflation) derived from the CPI headline exceeding 1.5%. Critically, two such episodes—2017-18 to 2019-20 and the ongoing 2024-25 period—have occurred under the FIT regime. This suggests that the framework, in its current form, can sometimes lead to monetary policy settings that are excessively tight, potentially stifling growth. The solution, however, is not to jettison FIT altogether. History shows that such episodes of excessive monetary tightening also occurred prior to FIT, for instance, in the 1990s. Furthermore, the alternative—the high double-digit inflation of the 1970s and early 2000s—also resulted in low growth, proving that runaway inflation is a surefire path to economic stagnation, regardless of how low interest rates are.

Fine-Tuning the Parameters: A Surgical Approach

The RBI’s discussion paper poses several specific questions, and the answers, as argued by Goyal, largely favour maintaining the core structure while introducing critical flexibilities.

First, on the choice of the inflation target, the argument for retaining headline CPI inflation as the primary anchor is strong. Despite structural changes in the economy, food items continue to command a significant weight in the Indian consumption basket. Food prices directly impact inflation perceptions among households and are a critical determinant of welfare, especially for low-income families. Shifting the focus away from headline inflation could risk ignoring these very real pressures on the common citizen.

Second, the numerical target of 4% remains appropriate. Over the FIT period, while headline inflation averaged 5%, the more stable core inflation (which excludes volatile food and fuel components) has hovered around 4%. Economic research consistently shows that the more volatile headline inflation tends to converge to the core over time. This indicates that inflation expectations are gradually becoming anchored at the 4% mark. A study using disaggregated industrial data even suggests that inflation expectations are as low as 3%. This anchoring is a monumental achievement of the FIT regime, as it creates a stable focal point for price-setting by businesses and wage negotiations by workers, thereby creating a self-reinforcing cycle of price stability.

Third, the tolerance band of +/- 2% should not be narrowed. This band has proven its worth by providing the MPC the necessary flexibility to “look through” transient supply shocks, often driven by global commodity prices or erratic monsoons. Reducing the band would constrain the MPC’s ability to respond pragmatically to these exogenous shocks, which are a recurring feature of an emerging economy like India. Markets, of course, prefer a point target to guide their expectations, and the 4% target serves that purpose. The key is to implement this target with flexibility, acknowledging that rigid adherence in the face of a supply shock can be counterproductive.

Enhancing Communication and Institutional Memory

A major, albeit understated, achievement of the FIT framework has been to reduce the element of personality-driven discretion in monetary policy. By establishing a committee-based, rule-bound system, it has enhanced the predictability and credibility of the RBI. However, to solidify this institutional strength, more needs to be done to build institutional memory and continuity. A situation where all MPC members change at the same time, as apparently happened last year, is detrimental. Staggered tenures would ensure that the committee always benefits from the experience of members who have witnessed previous economic cycles.

Communication strategy is another area ripe for refinement. While the target remains headline inflation, the RBI should also start making its forecasts for core inflation public. This would help anchor public expectations at the more stable trend inflation rate of 4%, reducing the excessive focus on short-term spikes in vegetable or fuel prices. A lesson from the past is instructive: in the 2000s, the weekly reporting of rising food prices entrenched public perception of high inflation, making it harder to control. Furthermore, RBI’s current forecasts have been noted to be conservative, often reverting to past trends. Given that markets closely follow these forecasts to predict policy, there is a need for more independent, high-quality academic forecasts to enrich the public discourse.

The process of forecasting itself can be improved. Over-reliance on year-on-year inflation figures can create large distortions due to base effects. A greater emphasis on momentum, or month-on-month changes, in official communication would provide a more accurate picture of the current inflationary pressures. In an economy that pays close attention to official communication, this shift could significantly speed up the process of anchoring inflation expectations.

Understanding True Flexibility: Beyond the AE Textbook

India adopted FIT in a hurry, following a period of uncomfortably high inflation. In doing so, it largely imported the canonical model from advanced economies (AEs). In this model, flexibility is narrowly defined as the tolerance band and the time given to bring inflation back to target. However, this model is not a one-size-fits-all solution. Emerging Markets (EMs) like India face a fundamentally different set of challenges, requiring a customised approach.

It is often not realized that the spirit of the Multiple Indicator Approach, which was specifically designed for Indian conditions prior to FIT, continues under the current framework. The MPC, in its deliberations, does consider a wide array of variables affecting both inflation and growth. The complexity is simply distilled into two primary communication variables—inflation and growth—for the sake of clarity. This is a pragmatic adaptation, not an abandonment of a holistic view.

EM central banks cannot afford to rely on a single instrument—the policy interest rate. The standard AE model of strict inflation targeting is coupled with a fully floating exchange rate and endogenous adjustment of liquidity. This is unworkable in an EM context. In India, the exchange rate policy necessarily involves strategic intervention, reserve accumulation, and the use of prudential tools to manage volatile capital flows. These various instruments—monetary, exchange rate, and macroprudential—need to be carefully aligned to avoid working at cross-purposes. For instance, in conditions of large exogenous shocks and segmented financial markets, the RBI must often maintain a surplus of durable liquidity to ensure stability, a practice that a strict AE inflation targeter might find unconventional.

Furthermore, the institutional relationship with the government requires a different model. The canonical AE prescription is central bank independence, often interpreted as a strict separation from the fiscal authority. In India, where supply-side issues (like food prices or infrastructure bottlenecks) are a major driver of inflation, this is inefficient. Fiscal action is often more effective against supply-side inflation. Therefore, what is required is not a rigid independence but a strategic coordination with the government. To ensure this coordination survives changes in political leadership, there could be an explicit allocation of some responsibility to the government for managing commodity price shocks, perhaps through a pre-announced strategy for the counter-cyclical use of oil excise taxes. This would not only manage inflation but also encourage long-term, productivity-enhancing interventions, ensuring that India’s limited resources are used optimally.

Finally, the very mandate of the RBI, as per the amended RBI Act, is to “maintain price stability, while keeping in mind the objective of growth.” To better reflect the national objectives enshrined in the vision of Viksit Bharat (Developed India), Goyal suggests a subtle but powerful rewording: “maintain price stability while protecting growth.” This change in emphasis would formally acknowledge that in a country where millions aspire for better living standards, growth cannot be a secondary consideration; it must be protected and nurtured even as the central bank vigilantly guards against inflation.

Conclusion: A Made-in-India Model for Monetary Policy

The ongoing review of India’s monetary policy framework is a rare opportunity. It is a chance to learn from the successes and shortcomings of the past eight years to build a more robust, resilient, and relevant framework for the future. The RBI discussion paper is a commendable first step, but as Ashima Goyal’s analysis shows, the debate must be more extensive and delve deeper. The goal should be to create a distinctly Indian version of inflation targeting—one that is flexible, intelligent, and responsive to the realities of an emerging market giant. It must be a framework that can simultaneously protect the poor from the ravages of high inflation and foster the investment and growth needed to lift the nation to new heights. By fine-tuning, not forsaking, FIT, India can solidify its hard-won macroeconomic stability and pave the way for a period of sustained, inclusive growth.

Q&A on India’s Inflation Targeting Framework

1. The article mentions that real interest rates above 1.5% have sometimes coincided with lower growth under FIT. Does this mean the FIT framework has failed?

No, it would be incorrect to label the FIT framework a failure. The data clearly shows its primary success: a significant reduction in the average headline inflation from 8.5% in the pre-FIT era to 5% post-FIT. The observation about real interest rates and growth highlights a specific shortcoming or a side-effect, not a total failure. It indicates that the framework’s implementation can, at times, lead to monetary policy that is tighter than what the growth situation warrants. The key takeaway is the need for fine-tuning—making the framework more sensitive to growth indicators without compromising the hard-won gains on inflation control. The solution lies in introducing more flexibility in how the target is pursued, not in abandoning the target itself.

2. Why is there a recommendation to continue targeting ‘headline’ inflation instead of the more stable ‘core’ inflation?

There are two primary reasons for sticking with headline CPI inflation as the target. First, political and welfare relevance: Food items have a large weight in the Indian consumer’s basket. Sharp rises in food prices cause significant public distress and can shape inflation expectations powerfully, even if they are theoretically “transitory.” Ignoring headline inflation would mean ignoring the lived experience of a vast majority of Indians. Second, accountability: Headline inflation is what citizens feel. Shifting to a core inflation target, which excludes food and fuel, could be perceived as the central bank sidestepping its core responsibility of managing the cost of living that truly affects the populace.

3. What does “true flexibility” for an Emerging Market (EM) like India entail, beyond the official tolerance band?

For an EM like India, true flexibility goes far beyond the +/- 2% band. It includes:

• Multiple Instruments: Using not just the policy repo rate, but also forex intervention, liquidity management, and macroprudential tools to manage capital flows and financial stability.

• Coordinated Fiscal-Monetary Response: Acknowledging that supply shocks (e.g., from food or oil) require fiscal measures (like adjusting excise taxes) and that close, formal coordination with the government is more effective than a rigid, “hands-off” independence.

• Liquidity Management: Actively ensuring durable liquidity is in surplus during times of large external shocks to prevent market seizures, a practice that differs from the AE model.

• Communication Strategy: Focusing on core inflation forecasts and momentum (month-on-month changes) to guide expectations, rather than being solely driven by volatile headline numbers and backward-looking base effects.

4. How can the institutional strength of the Monetary Policy Committee (MPC) be enhanced?

The institutional strength of the MPC can be bolstered by ensuring greater continuity and institutional memory. A critical step would be to avoid a situation where all external members of the MPC are replaced simultaneously. Implementing staggered tenures would guarantee that the committee always includes members with experience of previous policy cycles, leading to more informed and consistent decision-making. This reduces the risk of policy volatility due to a complete change in the committee’s composition.

5. The article suggests a change in the RBI’s mandate wording. What is the proposed change and why is it significant?

The proposed change is to alter the mandate from “maintain price stability, while keeping in mind the objective of growth” to “maintain price stability while protecting growth.” This is significant because it represents a subtle but powerful shift in emphasis. The current phrasing can be interpreted as making growth a secondary, almost optional, consideration. The new wording places growth and price stability on a more balanced footing, explicitly acknowledging that in a developing economy with immense aspirations, the central bank’s policy must be designed to safeguard the growth process from being unnecessarily curtailed. It formalizes the “flexibility” in Flexible Inflation Targeting, giving the MPC a clearer mandate to avoid excessively tight monetary policy that could stifle economic expansion.