India’s Inflation Targeting Framework and Economic Challenges

India’s inflation targeting framework, adopted formally in 2016, aimed to stabilise prices by setting a target inflation rate of 4 per cent with a tolerance band of ±2 per cent. This policy followed recommendations from key committees and agreements between the Government and the Reserve Bank of India (RBI). However, recent debates question the effectiveness of inflation targeting in India’s unique economic context, especially given the rising growth ambitions and structural challenges in food inflation and employment.

Background of Inflation Targeting in India

India implemented inflation targeting after the Urjit Patel Committee recommended it in 2014. The Monetary Policy Framework Agreement of 2015 formalised this approach. The RBI’s Monetary Policy Committee (MPC) was tasked with maintaining inflation within the specified band. The policy aimed to anchor inflation expectations and provide clarity to markets and consumers.

Effectiveness of Repo Rate in Controlling Inflation

The repo rate is the main tool used by the RBI to influence inflation. However, data since 2016 shows a weak negative correlation (-0.43) between repo rate changes and headline inflation. This indicates limited transmission of monetary policy to inflation control. Banks often do not reduce lending rates in line with repo cuts, weakening the impact on consumer demand and prices.

Role of Food Inflation in India’s Price Dynamics

Food inflation explains nearly 73 per cent of variations in headline inflation. Food accounts for 46 per cent of India’s consumer price index (CPI) basket, making it a dominant factor. However, food inflation is largely driven by supply-side issues such as monsoon variability, supply chain inefficiencies, and agricultural policies. The correlation between food inflation and repo rate is very weak (-0.19), showing monetary policy cannot effectively control food prices.

Structural Challenges in Food Supply Chains

Key crops like tomatoes, onions, and potatoes heavily influence food inflation. Addressing food inflation requires investment in storage, cold chains, food processing, and infrastructure to withstand weather shocks. These areas lie outside the scope of monetary policy and need targeted structural reforms and fiscal support.

Institutional Credibility and Inflation Stability

Inflation stability since 2016 owes more to the RBI’s statutory commitment and fiscal prudence than to repo rate changes. The government has maintained manageable fiscal deficits and debt levels, which has anchored inflation expectations. This institutional credibility has helped prevent runaway inflation despite limited monetary policy traction.

Global Comparisons of Inflation Policy

Major economies like the US, China, and Japan do not follow strict inflation targeting. The US Federal Reserve balances price stability with employment goals. China pursues multi-objective policies including growth and financial stability. The Bank of Japan uses a flexible approach. Countries with lower food shares in their CPI baskets, like the UK and EU, find inflation targeting more effective. India’s high food share makes strict inflation targeting less suitable.

Need for a Broader Monetary Policy Mandate

Given the structural nature of food inflation and the challenges of jobless growth, India may benefit from a flexible monetary policy framework. This could include employment and growth alongside inflation targets. Fiscal policy constraints under the Fiscal Responsibility and Budget Management (FRBM) Act limit government manoeuvre, placing greater responsibility on monetary policy to support inclusive growth.

Policy Implications for India’s Growth

Balancing inflation control with growth and employment is crucial for India’s vision of Viksit Bharat (Developed India). Strengthening food supply chains and infrastructure requires fiscal and sectoral reforms. Monetary policy may need to evolve beyond inflation targeting to address the country’s structural economic realities and support broader development goals.

Questions for UPSC:

1. Point out the challenges and limitations of inflation targeting in emerging economies with special reference to India.
2. Critically analyse the role of monetary policy in managing food inflation and supply-side constraints in India with suitable examples.
3. Estimate the impact of fiscal prudence on inflation expectations and economic stability in India since 2016.
4. What is the dual mandate of the US Federal Reserve? How can India adapt a flexible monetary policy framework to balance inflation and employment goals?

Answer Hints:

1. Point out the challenges and limitations of inflation targeting in emerging economies with special reference to India.

1. High share of food in CPI (46% in India) causes food inflation to dominate headline inflation, limiting monetary policy impact.
2. Food inflation is largely supply-driven and structural—affected by monsoons, supply chains, and agricultural policies, beyond RBI’s control.
3. Weak transmission mechanism – repo rate changes show low correlation (-0.43) with headline inflation and minimal impact on lending rates.
4. Monetary policy cannot effectively control supply-side shocks and price volatility in essential commodities.
5. Institutional credibility helps anchor inflation expectations, but inflation targeting alone cannot ensure price stability in emerging contexts.
6. Emerging economies often face fiscal constraints and structural bottlenecks making strict inflation targeting less optimal.

2. Critically analyse the role of monetary policy in managing food inflation and supply-side constraints in India with suitable examples.

1. Monetary policy tools like repo rate have negligible effect on food inflation (correlation -0.19), which is supply-driven.
2. Food inflation driven by weather (monsoons), supply chain bottlenecks, logistics, and minimum support prices.
3. Examples – Price spikes in tomatoes, onions, potatoes influence overall food inflation.
4. Structural investments needed in storage, cold chains, and food processing to reduce volatility—outside monetary policy scope.
5. Monetary policy can influence demand-side inflation but cannot fix supply constraints causing food price rises.
6. Thus, relying solely on monetary policy to control food inflation is ineffective; fiscal and sectoral reforms are essential.

3. Estimate the impact of fiscal prudence on inflation expectations and economic stability in India since 2016.

1. Fiscal discipline maintained deficits within limits (except pandemic period), supporting macroeconomic stability.
2. Debt-to-GDP ratio kept manageable, reinforcing confidence in government’s fiscal management.
3. Fiscal prudence complements RBI’s inflation targeting by anchoring inflation expectations firmly.
4. Stable fiscal policy reduces risk of demand-pull inflation and inflationary pressures from government borrowing.
5. Institutional credibility from combined fiscal-monetary prudence prevents runaway inflation despite monetary transmission issues.
6. Helps create virtuous cycle of low inflation expectations, supporting overall economic stability and growth prospects.

4. What is the dual mandate of the US Federal Reserve? How can India adapt a flexible monetary policy framework to balance inflation and employment goals?

1. US Fed’s dual mandate – price stability (inflation control) and maximum sustainable employment.
2. Fed uses flexible frameworks balancing inflation targets with labor market and growth objectives.
3. India’s current framework focuses mainly on inflation targeting, ignoring employment and growth explicitly.
4. India can broaden RBI’s mandate to include employment and growth, addressing jobless growth and youth unemployment.
5. Flexible policy could allow trade-offs between inflation and employment, adapting to structural realities like food inflation.
6. This approach aligns monetary policy with inclusive growth goals and complements fiscal efforts for Viksit Bharat vision.