A Decade of Flexible Inflation Targeting in India: Achievements and Challenges

Introduction

India has completed a decade of the Flexible Inflation Targeting (FIT) framework, prompting fresh debate over its effectiveness. An empirical evaluation published in the Economic and Political Weekly (EPW) has raised critical questions about the framework's underlying theoretical assumptions and real-world efficacy in the Indian economy.

What is Flexible Inflation Targeting (FIT)?

Definition

FIT is a monetary policy framework where the central bank uses interest rates to keep inflation within a specific, publicly announced target range while simultaneously keeping the objective of economic growth in mind.

Historical Background

• New Zealand was the first country to adopt inflation targeting globally in 1990
• India formally adopted FIT in 2016 following the Urjit Patel Committee's recommendations
• Section 45-ZA of the amended Reserve Bank of India (RBI) Act, 1934 mandates the government to set the inflation target in consultation with the RBI every five years

The Target and Anchor

• India has retained the 4% retail inflation target (with +/- 2% band) for the next 5-year period (1st April 2026 to 31st March 2031)
• The primary anchor used to measure this is the Headline Consumer Price Index (CPI-Combined) (with base year 2024)

Accountability Mechanism

If average inflation breaches the 2–6% tolerance band for three consecutive quarters, the RBI is deemed to have failed its mandate and must submit a written report to the government explaining the reasons and outlining remedial actions.

Working of Inflation Targeting

The RBI seeks to control inflation through two primary channels:

1. Aggregate Demand Channel

When inflation rises, the RBI increases the policy repo rate. This:

• Pushes up commercial lending rates
• Makes home and consumer loans expensive
• Leads households and businesses to postpone spending and investment
• Brings down overall demand and cools inflation

2. Expectations Channel

By setting a clear target, the RBI attempts to tether the public's future inflation expectations:

• If people expect prices to remain stable, workers will not demand aggressive wage hikes
• Businesses will not preemptively raise prices
• Prevents a self-fulfilling inflationary spiral

Concerns Regarding the FIT Framework

1. A "Flat" Phillips Curve

• Empirical data from April 2012 to March 2026 indicates India's New Keynesian Phillips Curve (NKPC) is effectively flat
• Implies a weak relationship between output and inflation
• Aggressive interest-rate hikes could cause significant losses in output and employment without a commensurate decline in inflation
• Potentially increasing the risk of stagflation

2. Flawed Assumptions on Wages

• Traditional macroeconomic model assumes rising output leads workers to demand higher wages, pushing up prices
• However, in India, nearly 92% of the workforce operates in the informal sector with no wage-bargaining power
• They are simply "price takers," breaking the assumed theoretical link between output and wage-led inflation

3. Unanchored Inflation Expectations

• Household inflation expectations have consistently outpaced RBI projections by an average of 4 percentage points
• Suggests the monetary policy's 'expectations channel' has not successfully anchored public sentiment

4. Supply-Side Dominance

• Indian inflation is often driven by:
• Food-price volatility
• Monsoon shocks
• Fuel-price fluctuations
• Global supply-chain disruptions
• As monetary policy is primarily a demand-management tool, it cannot directly resolve supply-side shortages
• Monetary tightening may suppress demand, output and employment without delivering sustained inflation reduction

5. High Liquidity Challenges

• The RBI frequently faces challenges managing surplus systemic liquidity (e.g., from forex currency defense operations)
• This surplus liquidity exerts downward pressure on overnight interest rates
• Works directly against the central bank's tight inflation stance

Arguments in Favour of the FIT Regime

1. Macroeconomic Stability

• Average inflation has declined significantly under the FIT regime compared to pre-2014 era when CPI frequently hovered near 10%
• During 2016–2025, FIT showed a hump-shaped performance ("inverted-U curve"):
• Initial three years: Inflation broadly aligned with 4% target
• Middle period: Moved towards 6% upper tolerance limit (Covid-19 pandemic and Russia-Ukraine conflict)
• Final period: Returned towards target
• Since adoption of FIT in 2016, average inflation declined to 4.9%, compared with 6.8% during pre-FIT period

2. Optimal Growth Threshold

• A recent RBI research paper mapping the quadratic inflation-growth curve (1991 to 2023, excluding Covid years) found India's economic growth is maximized when inflation is kept near the 4% central target

3. Institutional Credibility

• The statutory backing of the Monetary Policy Committee (MPC) has enhanced institutional independence of the RBI
• Stabilized inflation expectations of markets
• Shielded monetary policy from fiscal dominance

New Keynesian Phillips Curve (NKPC)

The NKPC outlines the theoretical relationship between a country's level of economic output and its inflation:

• The model proposes that an increase in economic output and employment strengthens workers' bargaining power
• Workers can demand higher wages
• Since prices act as a markup over wage costs, a rise in wages inevitably leads to a rise in prices
• This gives the NKPC an upward-sloping shape

According to this theory, policymakers can control inflation either by:

1. Reducing output (sliding down the curve), or
2. Lowering public expectations (shifting the entire wage curve downward)

Measures to Enhance the FIT Framework in India

1. Create a Joint Food Inflation Response Cell

• Establish an RBI–Consumer Affairs Ministry mechanism
• Trigger: 6% three-month food-inflation threshold
• Actions: Automatic buffer-stock releases, pulse sales, calibrated import-duty cuts
• Reduces pressure on MPC to respond to supply shocks through rate hikes

2. Re-evaluating the Policy Anchor

• Debate merits of targeting Core Inflation (excludes volatile food and fuel prices) versus Headline CPI
• Ensures monetary policy is not held hostage by temporary agricultural shocks

3. Strengthen Rate Transmission to Informal Credit

• Extend transparent benchmark-linked pricing to NBFCs and MFIs
• Expanded credit guarantees for MSMEs
• Ensures repo-rate changes reach the informal economy where conventional monetary transmission remains weak

4. Revive Retail Inflation-Indexed Bonds

• Reintroduce liquid, retail-oriented inflation-indexed bonds with regular interest payouts
• Gives households a credible inflation hedge
• Reduces reliance on physical assets such as gold

5. Set Explicit Second-Round Effect Indicators

• Define measurable conditions such as:
• Persistent food inflation alongside sustained rise in core inflation
• Criteria for assessing second-round effects before initiating additional monetary tightening
• Makes MPC decisions more predictable and reduces unnecessary growth costs

Key Constitutional and Legal Provisions

Monetary Policy Committee (MPC) Structure

• Composition: 6 members (as per 2016 amendments)
• Chairperson: RBI Governor (ex-officio)
• Members: Three RBI officials and three government-nominated members
• Function: Decides RBI's benchmark interest rates
• Reconstitution: Every four years

Conclusion

The FIT framework has delivered tangible results in reducing India's average inflation rate. However, structural challenges—particularly India's large informal economy, supply-side inflation drivers, and unanchored expectations—require a coordinated approach combining monetary policy with supply-side measures. Strengthening FIT requires better inflation-expectation management, stronger monetary transmission, and mechanisms to address food and fuel shocks without imposing excessive costs on growth and employment.