Inflation Targeting Framework

The Inflation Targeting Framework refers to a monetary policy regime in which a central bank publicly commits to achieving a specified rate of inflation over a medium-term horizon and uses policy instruments, primarily interest rates, to achieve this objective. In India, the adoption of inflation targeting marked a fundamental shift in monetary policy, placing price stability at the centre of macroeconomic management. In the context of banking, finance and the Indian economy, the framework has reshaped monetary transmission, financial market expectations and policy credibility.
Inflation targeting aims to anchor inflation expectations, enhance transparency in policymaking and support sustainable economic growth by maintaining macroeconomic stability.

Background and evolution of inflation targeting in India

Prior to adopting inflation targeting, India followed a multiple-indicator approach to monetary policy. The central bank monitored a wide range of variables, including growth, money supply, credit conditions, exchange rates and inflation. While this approach offered flexibility, it often lacked clarity in policy signalling.
Persistent inflationary pressures, particularly during periods of high food and fuel prices, highlighted the need for a clearer nominal anchor. Following expert committee recommendations and global best practices, India formally adopted an inflation targeting framework in the mid-2010s, institutionalising price stability as the primary objective of monetary policy.

Legal and institutional framework

The inflation targeting regime in India is embedded in the statutory mandate of the Reserve Bank of India. The framework specifies a numerical inflation target, measured by the Consumer Price Index, along with a tolerance band around the target.
Monetary policy decisions are taken by the Monetary Policy Committee, a statutory body that combines central bank officials and external members. This institutional arrangement strengthens accountability, reduces discretionary bias and enhances policy credibility.

Inflation target and policy mandate

Under the framework, the primary objective of monetary policy is to maintain price stability, while keeping in mind the objective of growth. The inflation target provides a clear benchmark against which policy performance can be evaluated.
By committing to a defined target range, the central bank communicates its policy intentions more effectively to markets, businesses and households. This transparency helps anchor inflation expectations and reduces uncertainty in economic decision-making.

Transmission to the banking system

Inflation targeting relies heavily on effective monetary transmission through the banking system. Policy rate changes influence banks’ lending and deposit rates, affecting consumption, investment and savings decisions.
In India’s bank-dominated financial system, improvements in transmission mechanisms—such as external benchmarking of lending rates—have strengthened the link between policy signals and market interest rates. As a result, inflation targeting has increased the responsiveness of banks to monetary policy actions.

Impact on financial markets

The inflation targeting framework has had a significant impact on financial markets. Clear policy signals reduce uncertainty, stabilise bond yields and improve pricing of financial assets.
Government securities markets, in particular, benefit from lower inflation risk premiums when policy credibility is strong. This reduces borrowing costs for the government and supports more efficient capital allocation across the economy.

Implications for economic growth

While inflation targeting prioritises price stability, it also supports sustainable growth by reducing macroeconomic volatility. High and unpredictable inflation distorts savings and investment decisions, disproportionately affecting lower-income households.
By maintaining low and stable inflation, the framework creates a favourable environment for long-term investment, productivity growth and financial deepening. In this sense, price stability is viewed as a precondition for durable economic expansion.

Role during economic shocks

The inflation targeting framework is designed to be flexible, allowing the central bank to respond to supply-side shocks such as food price spikes or global commodity volatility. Temporary deviations from the target are permitted, provided inflation converges back to the target over the medium term.
This flexibility is particularly important for India, where inflation is often influenced by structural and supply-side factors beyond the immediate control of monetary policy.

Criticisms and challenges in the Indian context

Despite its benefits, inflation targeting in India faces certain challenges. Food and fuel prices, which form a significant part of the consumption basket, are subject to supply shocks and administrative interventions.
Critics argue that a strict focus on inflation may constrain growth during economic slowdowns. Others highlight the limitations of interest rate policy in addressing supply-driven inflation. These concerns underscore the need for coordination between monetary, fiscal and supply-side policies.

Interaction with fiscal policy

The effectiveness of inflation targeting is closely linked to fiscal discipline. Large fiscal deficits can undermine price stability by increasing aggregate demand and inflationary pressures.
The framework encourages fiscal prudence, as predictable and stable inflation outcomes depend on coherent macroeconomic policy coordination between the government and the central bank.