India’s Flexible Inflation Targeting Framework: Stability, Growth & Future Options
(UPSC GS Paper III – “Indian Economy: Monetary policy, Inflation and Growth”)
Context (Introduction)
India’s Flexible Inflation Targeting (FIT) framework—mandating a 4% inflation target with a ±2% band—comes up for review in March 2026. The RBI’s discussion paper reopens key questions on headline vs. core inflation, acceptable inflation levels, and the applicable target band.
Main Arguments
- FIT has stabilised inflation despite shocks: Since adoption in 2016, inflation has remained broadly range-bound, even through episodes such as COVID-19, commodity spikes, and supply disruptions. The framework improved policy predictability and institutional autonomy.
- Headline inflation is the appropriate target: Because inflation affects savings, investments, and disproportionately harms the poor, the headline inflation, not core inflation, should be targeted. Food inflation often reflects monetary conditions, not merely supply shocks.
- Monetary policy influences general price level: As Friedman had said that without expansion in overall liquidity, sustained inflation cannot occur. Food inflation can create second-round effects—through wages and cost pass-through—making it relevant for monetary policy.
- Acceptable inflation for India is around 4%: Historical data (since 1991, excluding the COVID year) show a non-linear inflation–growth relationship, with a turning point near 3.98%. This supports continuing the 4% target. Simulations for 2026–2031 also suggest inflation below 4% as consistent with stable growth.
- The current ±2% band provides adequate flexibility: The existing 2–6% tolerance band has helped the RBI manage shocks. However, the article warns that staying persistently near the upper bound undermines the spirit of FIT, especially since growth declines sharply beyond 6%.
Criticisms / Drawbacks
- Debate confused between relative and general prices: Public discourse often overlooks that food-price movements reflect both supply shocks and monetary expansion. Without distinguishing these, arguments for core inflation targeting become misleading.
- Phillips Curve evidence weak in India: India’s data show only a short-run inflation–growth trade-off; long-run trade-offs are unconvincing. High inflation eventually harms growth, reinforcing the case for a firm target.
- Risk of fiscal slippage undermining FIT: Historically, monetisation of fiscal deficits in the 1970s–80s caused chronic inflation. FIT works only when complemented by fiscal discipline under FRBM. Weakening either framework harms macro stability.
- Lack of clarity on duration near upper band: The current framework does not specify how long inflation can remain near 6% without triggering accountability mechanisms, diluting the credibility of the target.
- Arguments for higher targets lack empirical basis: Preliminary empirical simulations indicate no justification for raising the target above 4%. Higher targets risk unanchoring expectations and reducing the RBI’s credibility.
Reforms and Way Forward
- Retain headline CPI as the primary target: Given India’s consumption patterns and the welfare impact of food inflation, headline CPI remains the most relevant indicator for policy credibility and public welfare.
- Maintain the 4% target with stricter accountability norms: A mid-course review mechanism could be introduced to scrutinise policy stance if inflation remains close to 6% for prolonged periods.
- Strengthen FRBM–FIT coordination: Fiscal dominance must be avoided. Clear fiscal glide paths, reduced off-budget borrowings, and better debt transparency will support monetary policy effectiveness.
- Improve inflation forecasting and food-market reforms: Strengthen early-warning systems for food inflation; improve agri-logistics, cold chains, and storage to reduce supply volatility. Better forecasting reduces policy lags.
- Conduct periodic empirical assessments of threshold inflation: Every review cycle (5 years) should incorporate updated structural models to determine threshold inflation levels consistent with evolving growth prospects, external risks, and fiscal realities.
Conclusion
India’s experience since 2016 shows that FIT has anchored expectations and contained inflation despite repeated shocks. Evidence suggests that a 4% target with a ±2% band strikes a practical balance between stability and flexibility. Going forward, policy success will depend on maintaining fiscal discipline, refining inflation forecasting, and ensuring that headline inflation—not just core—remains firmly under control.
Mains Question
- “India’s Flexible Inflation Targeting framework is due for review in 2026. Critically examine whether the 4% target with a ±2% band remains appropriate in light of India’s inflation–growth dynamics.” (250 words, 15 marks)
Source: The Hindu