The Reserve Bank of India (RBI) is preparing to review its monetary policy framework by March 2026. The review focuses on the Flexible Inflation Targeting (FIT) regime adopted in 2016. The RBI has invited public comments on whether to retain or revise the current inflation target and its tolerance band. Former Monetary Policy Committee (MPC) members mostly support maintaining the existing framework. The key debate revolves around the 4 per cent Consumer Price Index (CPI) inflation target, its tolerance band, and whether headline or core inflation should guide policy.
Background of RBI’s Inflation Targeting
In August 2016, India officially adopted a CPI inflation target of 4 per cent with a tolerance band of 2-6 per cent. This target is reviewed every five years by the Central government in consultation with the RBI. The aim is to stabilise inflation expectations and support sustainable economic growth. Since shifting focus from wholesale to retail inflation in 2014, CPI inflation has gradually declined. It is projected to average 3.1 per cent in the current fiscal year, the lowest since the FIT regime began.
Arguments for Retaining the 4% Target
Most former MPC members advocate keeping the 4 per cent target unchanged. They argue it has helped stabilise inflation expectations and contributed to economic stability. Ashima Goyal, an MPC member till 2024, states the process is ongoing and should not be disturbed. Janak Raj, former RBI executive director, warns that changing the target or tolerance band now carries risks and suggests continuing with the current framework for another five years.
Debate on Revising the Inflation Target
Some experts propose revising the target and tolerance band. Ravindra Dholakia, former MPC member, suggests raising the target to around 5.5 per cent to better accommodate India’s structural growth needs. Others recommend narrowing the tolerance band from 2-6 per cent to 2-5.5 per cent and lowering the target to 3.5 per cent gradually. However, critics show frequent breaches of the upper tolerance limit in the past decade, cautioning that a narrower band might undermine the credibility of the RBI’s inflation control.
Headline vs Core Inflation Focus
The 2023-24 Economic Survey raised the question of whether RBI should focus on headline inflation or exclude food prices from its target. Food accounts for about 46 per cent of the CPI basket and is influenced largely by supply-side factors beyond RBI’s control. The RBI, however, maintains that food prices cannot be ignored as they impact household expenses and overall inflation.
Importance of Inflation Targeting for Growth
Low and stable inflation is crucial for economic growth. High inflation erodes consumer purchasing power. Very low inflation may reduce producers’ incentives to supply goods and services. The FIT regime aims to balance these effects by anchoring inflation expectations and providing a predictable environment for businesses and consumers.
Future Review and Policy Implications
The RBI’s review, to be completed by March 2026, will consider public feedback on four key questions – whether to focus on headline or core inflation, the appropriateness of the 4 per cent target, changes to the tolerance band, and the possibility of replacing the target with a range. The final decision will influence India’s monetary policy direction in the coming years.
Questions for UPSC:
- Critically analyse the significance of inflation targeting in India’s monetary policy and its impact on economic growth since 2016.
- Explain the difference between headline and core inflation. What are the challenges for central banks in targeting each type of inflation? Illustrate with suitable examples.
- What are the implications of adjusting the inflation tolerance band in the Reserve Bank of India’s Flexible Inflation Targeting regime? Discuss with reference to credibility and economic stability.
- Comment on the role of supply-side factors such as food prices in inflation control. How can monetary policy and fiscal measures complement each other in managing inflation?
