Inflation Targeting In India

Inflation targeting is a monetary policy framework under which the central bank sets a specific inflation rate as its primary goal and uses interest rate and liquidity management tools to achieve it. In India, this framework was formally adopted in 2016, when the Reserve Bank of India (RBI) and the Government of India introduced a structured Monetary Policy Framework aimed at maintaining price stability as the key objective of monetary policy, while supporting economic growth.
This shift marked a transformation from India’s earlier multi-objective monetary policy—focused simultaneously on growth, employment, and stability—towards a more transparent, rule-based approach prioritising inflation control and credibility.

Background and Evolution

Before 2016, India’s monetary policy followed a multiple-indicator approach, relying on money supply, credit, interest rates, and exchange rate trends. However, during 2009–2013, India experienced persistently high inflation, often above 9 per cent, mainly due to supply shocks, global commodity price rises, and domestic fiscal pressures.
The high inflation period adversely affected household savings, increased uncertainty for investors, and complicated policy decisions. Recognising the need for a clearer framework, the Expert Committee to Revise and Strengthen the Monetary Policy Framework (2014), chaired by Dr. Urjit Patel, recommended:

• Adopting inflation targeting as the nominal anchor.
• Using Consumer Price Index (CPI) as the main measure of inflation.
• Establishing a Monetary Policy Committee (MPC) to ensure collective and evidence-based decision-making.

Following these recommendations, the Monetary Policy Framework Agreement (MPFA) was signed in February 2015 between the RBI and the Government of India. It formally introduced Flexible Inflation Targeting (FIT) as the cornerstone of India’s monetary policy.

Legal Framework

The inflation targeting mechanism was given statutory backing through amendments to the Reserve Bank of India Act, 1934, by the Finance Act, 2016. The key provisions included:

• Empowering the Central Government, in consultation with the RBI, to determine the inflation target every five years.
• Establishing the Monetary Policy Committee (MPC) to decide the policy interest rate required to meet the target.
• Ensuring accountability by mandating the RBI to report reasons and corrective actions if the target was missed for three consecutive quarters.

Inflation Target and Tolerance Band

Under the framework, the inflation target was set at 4 per cent Consumer Price Index (CPI) inflation, with a tolerance band of ±2 percentage points. This means that inflation is considered acceptable if it remains between 2 per cent and 6 per cent.
This target, first set for the period 2016–2021, was later extended until March 2026. The range allows flexibility for short-term shocks while maintaining long-term price stability.

The Monetary Policy Committee (MPC)

The Monetary Policy Committee was established in 2016 to institutionalise collective decision-making in monetary policy.
Composition:

• Three members from the RBI – including the Governor (Chairperson), the Deputy Governor (in charge of monetary policy), and one officer nominated by the RBI.
• Three members nominated by the Central Government – independent economists or experts in finance.

Decision Process:

• Each member has one vote; decisions are made by majority vote.
• In case of a tie, the RBI Governor has the casting vote.
• The MPC must meet at least four times a year, and its decisions and rationale are made public to enhance transparency.

If inflation exceeds or falls below the 2–6 per cent range for three consecutive quarters, the RBI is required to explain the reasons to the government, the proposed remedial steps, and the expected time frame for restoring the target.

Operational Mechanism

The RBI’s main instrument for controlling inflation is the policy repo rate—the rate at which it lends short-term funds to commercial banks.

• When inflation is above the target, the repo rate is raised to reduce demand and liquidity.
• When inflation is below target, the repo rate is lowered to encourage borrowing and investment.

Supporting instruments include:

• Reverse Repo Rate: Used to absorb excess liquidity.
• Cash Reserve Ratio (CRR): The portion of deposits banks must keep with the RBI.
• Open Market Operations (OMOs): Buying or selling government securities to regulate liquidity.
• Liquidity Adjustment Facility (LAF): Short-term lending and borrowing operations.

The framework is termed “flexible” because it allows the RBI to consider growth and financial stability while keeping inflation control as the primary goal.

Rationale for Inflation Targeting

The decision to adopt inflation targeting was driven by several key factors:

• Price Stability as a Growth Enabler: Stable prices reduce uncertainty and encourage investment and consumption.
• Credibility and Transparency: A clear inflation goal improves the public’s understanding of monetary policy actions.
• Expectation Management: Anchoring inflation expectations helps prevent self-fulfilling inflationary spirals.
• Institutional Accountability: The MPC provides a mechanism for collective, accountable decision-making.
• Global Alignment: Inflation targeting has been successfully adopted in several advanced and emerging economies, providing a tested policy framework.

Performance and Achievements

Since the adoption of inflation targeting, India has seen greater macroeconomic stability and better inflation management:

• Inflation Moderation: Between 2016 and 2020, headline CPI inflation largely remained within the 2–6 per cent range, barring temporary food and fuel shocks.
• Policy Credibility: The transparency of MPC decisions improved market confidence and reduced inflation expectations.
• Enhanced Financial Stability: Predictable policy actions contributed to more stable interest rates and better investment planning.

However, there have been challenges, especially during 2020–2022, when inflation breached the upper tolerance limit due to pandemic disruptions, global supply chain shocks, and energy price surges. Despite these pressures, the RBI’s calibrated policy response helped prevent major macroeconomic instability.

Limitations and Criticism

While the inflation targeting framework strengthened India’s monetary policy credibility, it has also faced certain criticisms:

• Supply-Side Dominance: A significant portion of India’s inflation stems from food and fuel prices, which are less responsive to interest rate adjustments.
• Growth-Inflation Trade-off: Tightening monetary policy to curb inflation may restrain economic growth and employment.
• Limited Fiscal Coordination: Inflation control also depends on fiscal discipline, which is outside the RBI’s direct control.
• Data and Transmission Constraints: Time lags in policy transmission and uneven credit distribution can dilute the effectiveness of interest rate changes.

Extension and Review

In March 2021, the Government of India, in consultation with the RBI, retained the 4 per cent target with a 2–6 per cent tolerance band for the next five-year period (2021–2026). The decision reflected the framework’s success in anchoring inflation expectations and maintaining monetary discipline.

Contemporary Relevance

Inflation targeting continues to guide India’s monetary policy amidst global uncertainties, energy price volatility, and post-pandemic recovery challenges. It ensures that monetary decisions remain data-driven and focused on sustainable price stability, which is vital for long-term growth and financial stability.
The RBI’s emphasis on communication, transparency, and analytical rigour under this framework has strengthened its institutional credibility and aligned India’s monetary policy with global best practices.