Flexible Inflation Targeting (FIT)

Flexible Inflation Targeting (FIT) is a monetary policy framework under which a central bank aims to maintain price stability by targeting a specified inflation rate, while allowing flexibility to support economic growth and financial stability. In the Indian context, FIT has become the cornerstone of monetary policy, shaping decisions related to interest rates, liquidity management, and overall macroeconomic stability. Its adoption marked a significant shift in the conduct of monetary policy, aligning India with global best practices while accommodating domestic economic realities.
In banking and finance, FIT influences credit conditions, savings behaviour, investment decisions, and expectations of households and businesses. For the Indian economy, it serves as a critical framework for balancing inflation control with growth objectives in a structurally diverse and developing economic environment.

Concept and Meaning of Flexible Inflation Targeting

Inflation targeting refers to a monetary policy strategy in which the central bank publicly announces a numerical target for inflation and uses policy instruments, primarily interest rates, to achieve that target. The term “flexible” indicates that the central bank does not pursue inflation control rigidly at the cost of output and employment, but allows short-term deviations to stabilise economic growth and financial markets.
Under FIT, price stability remains the primary objective, but secondary considerations such as output growth, financial stability, and external shocks are also taken into account. This flexibility is particularly important for emerging economies like India, which are frequently exposed to supply-side shocks such as food price volatility and global commodity price movements.

Evolution of Monetary Policy Framework in India

Prior to the adoption of FIT, India followed a multiple-indicator approach to monetary policy. The Reserve Bank of India monitored a wide range of indicators, including money supply, credit growth, exchange rates, output trends, and inflation, without a clearly defined nominal anchor.
Persistent inflationary pressures during the late 2000s and early 2010s highlighted the limitations of this approach. High and volatile inflation eroded purchasing power, distorted savings and investment decisions, and adversely affected economic growth. These challenges led to a growing consensus on the need for a more transparent and credible monetary policy framework.
The transition to Flexible Inflation Targeting was formalised following recommendations of expert committees, culminating in a revised monetary policy framework agreement between the Government of India and the RBI.

Adoption of Flexible Inflation Targeting in India

India officially adopted the Flexible Inflation Targeting framework in 2016 through amendments to the Reserve Bank of India Act, 1934. Under this framework, inflation is measured using the Consumer Price Index (CPI) as the nominal anchor.
The government, in consultation with the RBI, specified an inflation target of 4 per cent, with a tolerance band of ±2 per cent. This implies that inflation should remain between 2 per cent and 6 per cent. Failure to maintain inflation within this band for a sustained period requires explanation and corrective action.
A key institutional reform accompanying FIT was the establishment of the Monetary Policy Committee, which is responsible for setting the policy repo rate to achieve the inflation target.

Institutional Structure and Decision-Making Process

The Monetary Policy Committee consists of six members, three from the RBI and three external members appointed by the Government of India. Decisions are taken by majority vote, with the RBI Governor having a casting vote in case of a tie.
This committee-based system enhances transparency, accountability, and credibility of monetary policy. Policy decisions are communicated through detailed statements, press conferences, and published minutes, enabling financial markets and the public to better understand the rationale behind interest rate changes.

Role of FIT in Banking and Financial System

Flexible Inflation Targeting has significant implications for the banking and financial system in India. Since banks are highly sensitive to policy interest rates, changes in the repo rate directly affect lending and deposit rates.
Under FIT, predictable and stable inflation expectations help banks in pricing loans and deposits more efficiently. Lower inflation volatility reduces uncertainty, improves long-term planning, and strengthens the transmission of monetary policy through the banking system.
Additionally, FIT contributes to financial stability by discouraging excessive credit growth during inflationary phases and supporting accommodative policy during economic slowdowns. This balanced approach helps in maintaining the resilience of the financial system.

Impact on Savings, Investment, and Credit

From a financial perspective, FIT influences household and corporate behaviour. Stable inflation preserves the real value of savings, encouraging financial savings over physical assets such as gold and real estate. This supports capital formation and deepens financial markets.
For businesses, a credible inflation target reduces uncertainty about future costs and returns, promoting investment. Interest rate decisions under FIT also affect borrowing costs, influencing credit demand across sectors such as housing, infrastructure, and industry.
In the Indian economy, where bank credit remains a primary source of financing, the effectiveness of FIT is closely linked to the strength of monetary policy transmission.

Advantages of Flexible Inflation Targeting

The FIT framework offers several advantages in the Indian context.

• Provides a clear and transparent nominal anchor for monetary policy.
• Enhances the credibility and accountability of the central bank.
• Anchors inflation expectations of households and businesses.
• Improves coordination between monetary policy and fiscal discipline.
• Allows flexibility to respond to growth concerns and supply-side shocks.

These benefits contribute to macroeconomic stability, which is essential for sustained economic development.

Criticisms and Limitations of FIT in India

Despite its strengths, Flexible Inflation Targeting in India faces certain criticisms.

• Inflation in India is often driven by supply-side factors, such as food and fuel prices, which are less responsive to interest rate changes.
• Strict focus on inflation may constrain growth during periods of economic slowdown.
• Monetary policy transmission through banks may be weak due to structural issues.
• External shocks, such as global financial volatility, can complicate policy decisions.