Scrutinizing the Future of India’s Inflation Target
I. Introduction: The Road to the 2026 Monetary Policy Review
The Flexible Inflation Targeting (FIT) framework, which was officially adopted in 2016, represents the cornerstone of India's modern monetary policy. It has provided a clear, legally mandated objective for the Reserve Bank of India (RBI) and has been instrumental in steering the economy through a period of significant domestic and global turmoil . As the framework approaches its second statutory review, which is due by March 2026, the central bank has initiated a comprehensive public consultation . This process marks a crucial juncture for India's economic future, offering an opportunity to assess the ramework's past performance and calibrate it for the challenges that lie ahead .
This report serves as a detailed analysis of India's inflation targeting journey, its proven track record, and the pivotal policy debates that will define its next five years. The central bank's recently released discussion paper poses four key questions to stakeholders and the public, which form the core of the upcoming review . The feedback received by the September 18, 2025 deadline will inform the final recommendations that the RBI and the government will jointly make . These four questions are:
Should monetary policy be guided by headline inflation or core inflation?
Is the current 4% inflation target still appropriate for India?
Should the ±2% tolerance band be adjusted, either by narrowing, widening, or removing it?
Should the target remain a fixed midpoint (like 4%) or be replaced with a simple range (e.g., 3-6%)?
By exploring these questions, this report aims to provide a nuanced understanding of the delicate balance between maintaining price stability and fostering economic growth in a dynamic, rapidly evolving economy.
II. The Evolution of a Framework: India’s Journey to FIT
A. From Multiple Anchors to a Single Goal
Prior to the adoption of the FIT framework, India's monetary policy lacked a single, clear, and legally mandated objective. The policy often juggled multiple goals, including managing inflation, supporting growth, and stabilizing the exchange rate, often without a well-defined nominal anchor . This lack of a cohesive strategy contributed to a period of persistently high inflation in the years leading up to the framework's adoption. Consumer Price Index (CPI) inflation was a major concern, hovering around 10% up until the beginning of 2014, even as economic growth was decelerating . The high inflation rate was a leading concern for both economic policymakers and the general public .
A significant shift in policy direction occurred in 2013 under the leadership of then-RBI Governor Raghuram Rajan, who highlighted the importance of "low and stable expectations of inflation" and initiated a review of the country's monetary policy framework . The subsequent recommendation to adopt a flexible inflation-targeting regime based on headline CPI marked a fundamental change. The decision to anchor policy to the CPI was not merely a technical choice. The research shows that the CPI places a much larger weight on food, beverages, and tobacco, which have a combined weight of nearly 50% in the index, compared to around 25% in the Wholesale Price Index (WPI) . The subsequent debate over headline versus core inflation, as detailed in the RBI's discussion paper, reveals a deep conviction within the central bank that ignoring food prices would be detrimental to the welfare of the poor and would risk eroding public trust . The move to a CPI-based framework was, therefore, a strategic decision to align the central bank's mandate with a metric that is more representative of the actual cost of living for the majority of India's population. This choice was a deliberate and foundational step in building a framework that is both credible to financial markets and relevant to the average citizen's reality.
B. The Legal and Institutional Foundation
The formal journey to the FIT framework was anchored in a series of landmark legislative and institutional changes. The process began with the signing of a Monetary Policy Framework Agreement between the Government of India and the Reserve Bank of India on February 20, 2015 . This agreement formalized the objective of maintaining price stability while also keeping in mind the objective of growth .
The framework was given statutory backing in May 2016 through significant amendments to the Reserve Bank of India Act, 1934 . A key outcome of this legislative change was the establishment of the Monetary Policy Committee (MPC) to determine the policy interest rate . The MPC comprises six members: three from the RBI, including the Governor, and three government-appointed members . This structure moved the rate-setting decision from the Governor alone to a committee, thereby enhancing the transparency and credibility of the monetary policy process . The law also stipulated a review of the inflation target every five years, with the target first notified in August 2016 and then retained in March 2021 until March 2026 .
C. The Core Mandate and Its Components
The core of the framework, as outlined in the RBI Act, is to maintain a CPI inflation target of 4% with a tolerance band of ±2% . This structure is known as a point target with a tolerance band. The central bank's mandate is termed "flexible" because the law explicitly directs the RBI to maintain price stability "while keeping in mind the objective of growth" . This gives the central bank the necessary discretion to manage trade-offs between inflation and growth, which is a key feature of the framework .
A critical operational aspect of the framework is the legal definition of a policy failure. A failure is defined as breaching the target band for three consecutive quarters . This provision provides the central bank with essential flexibility, allowing it to "look through" temporary price spikes or supply shocks without being compelled to take immediate and potentially disruptive action . The forward-looking nature of the policy aims to align future inflation with the target, recognizing that monetary policy actions have a lagged effect on the economy.
III. Performance and Resilience: A Retrospective Analysis of the FIT Regime
A. A New Era of Price Stability
The RBI’s assessment is that the FIT framework has proven to be a success . This positive verdict is supported by a clear, data-driven comparison of the inflation landscape before and after the framework's adoption.
An analysis of inflation data reveals a significant improvement in price stability since 2016. The average inflation rate dropped to 4.9% in the post-FIT years, a marked decline from the 6.8% average observed in the pre-FIT era . Similarly, the volatility of inflation, a key measure of price instability, has fallen from 2.3% to 1.5% . These metrics demonstrate that the framework has provided a much-needed anchor for inflation expectations.
The framework's effectiveness is further underscored by recent data. In a testament to its success, the average year-on-year retail inflation, as measured by the CPI, fell from 5.4% in 2023-24 to 4.6% in 2024-25, reaching its lowest point in six years . The decline continued, with retail inflation dropping to 2.82% in May 2025 and further to 2.1% in June 2025 . This broad-based decline allowed the RBI to implement a 100 basis point cut in the policy repo rate since February 2025, demonstrating the framework's ability to facilitate a policy response that supports growth when inflationary pressures subside .
The table below provides a concise summary of India's inflation performance under the FIT regime.
Table 1: India's Inflation Performance: Pre- and Post-FIT Regime
B. Navigating Unprecedented Shocks
The true test of any monetary policy framework lies in its ability to withstand and respond to unforeseen economic shocks. The FIT framework has demonstrated remarkable resilience and adaptability in the face of two major crises: the COVID-19 pandemic and the Russia-Ukraine war.
During the initial phase of the pandemic, when economic activity was severely constrained, the Monetary Policy Committee used the framework's flexibility to prioritize growth . The RBI chose to "look through" the inflation spikes that were assessed to be temporary and driven by supply-side disruptions, rather than reacting with rate hikes that could have further damaged the economy . The RBI's assessment proved to be correct, as inflation receded once supply chains normalized and the pandemic subsided .
Conversely, when the Russia-Ukraine war triggered a sharp surge in commodity prices, pushing inflation above the 6% upper threshold, the MPC swiftly shifted its priorities . The central bank changed its policy stance to a "withdrawal of accommodation" and implemented a series of "frontloaded rate hikes" to contain prices . This rapid, decisive action to rein in inflation demonstrated the framework's capacity to adjust to a new set of challenges .
This ability to change its primary policy objective in response to the nature of the economic shock is a key strength of the framework. It operates as a "constrained discretion" model, which provides a precise numerical target for inflation over the medium term while allowing for a discretionary response to short-term economic shocks . This operational agility has, in effect, strengthened the central bank's credibility, proving that its flexibility is not a sign of weakness but a critical feature that allows it to effectively manage complex policy trade-offs . The framework's success in navigating these crises provides a compelling argument for its continued relevance and robustness.
IV. The Great Debate: Scrutinizing the Foundations of India’s FIT Framework
The upcoming review of the FIT framework is not a formality; it is a critical opportunity to re-evaluate the fundamental tenets of India's monetary policy. The RBI's discussion paper is a deep dive into four core questions that will shape the framework's future.
A. Targeting Inflation: Headline vs. Core?
One of the most significant debates is whether the central bank should continue to target headline CPI or shift its focus to core inflation . Headline inflation measures the total change in consumer prices, while core inflation excludes volatile food and fuel prices .
The RBI has made a strong and multifaceted case for retaining headline inflation as its primary target, an approach that is favored by almost all inflation-targeting countries worldwide, with Uganda being a rare exception . The arguments presented are not merely technical but also address the socio-economic realities of the Indian context:
Representativeness: Food and fuel prices constitute a significant portion of India's consumption basket, accounting for more than half of it . Excluding these components would make the inflation index less representative of the overall price conditions faced by the average citizen .
Welfare of the Poor: The central bank explicitly argues that disregarding food inflation would overlook the welfare of the poor, for whom food expenses are a dominant part of their household budgets . This demonstrates that the central bank's mandate extends beyond pure macroeconomic management to a socio-political responsibility, reinforcing its role as a socially conscious institution.
Spillover and Expectations: The RBI points out that persistently high food prices can influence public expectations and spill over into core inflation through higher wage costs, rents, and other channels . Empirical evidence suggests that non-core prices tend to converge with core prices over time, making them too important to be ignored .
Public Trust: Former RBI Governor Raghuram Rajan has cautioned that excluding food from the inflation metric could erode public trust . The RBI's discussion paper echoes this sentiment, with former Governor Shaktikanta Das noting that not having a target that the common person understands "will make no sense to the average citizen" . By targeting what directly impacts the most vulnerable, the central bank builds a foundation of public legitimacy that is crucial for its long-term effectiveness.
B. The Right Number: Is 4% Still Optimal?
The discussion paper asks whether the 4% inflation midpoint, set almost a decade ago, remains the most appropriate target . While the central bank defends its current target, some economists have argued in favor of raising it, perhaps to 6%, suggesting that the growth costs of a lower inflation target might outweigh the benefits in a fast-growing economy .
The argument for a slightly higher inflation target in an emerging economy is often supported by the Balassa-Samuelson effect, which suggests that economies experiencing rapid productivity growth in the tradable goods sector may see a relative increase in the prices of non-tradable goods, leading to slightly higher overall inflation .
Despite these arguments, the RBI has made a compelling case for retaining the 4% target. Empirical evidence cited in the discussion paper suggests that 4% is a desirable rate for India, as it keeps macroeconomic conditions at an optimal level with a zero output gap . Furthermore, the paper warns that raising the target at this time, amidst global geopolitical and geo-economic uncertainties, could be interpreted by global investors as a "dilution of the FIT framework," thereby undermining the credibility that has been painstakingly built over the last nine years .
C. The Zone of Comfort: Re-evaluating the Tolerance Band
The ±2% tolerance band around the 4% midpoint is a crucial component of the FIT framework, providing the central bank with the flexibility needed to manage shocks . The RBI has sought public input on whether this band should be adjusted—narrowed, widened, or even removed .
The broad band is justified by India's unusually high share of volatile food items in its consumption basket, which can induce significant price fluctuations . The band accommodates these supply shocks, as well as potential forecast and measurement errors .
However, the discussion on the band reveals a delicate paradox: the balance between flexibility and credibility. While the band provides essential flexibility, studies on emerging market economies (EMEs) show that missing a target range can be "particularly harmful for credibility" . The RBI's own paper states that "removing a specific target and continuing only with a band may signal the central bank's 'indifference' towards inflation outcomes" . This suggests that while flexibility is necessary, an unambiguous anchor for inflation expectations is paramount. The RBI's preference for a fixed midpoint (4%) within the band is a strategic choice designed to combine the best of both worlds: a clear, unwavering anchor for expectations while retaining the necessary operational flexibility to manage real-world shocks.
D. The Target’s Form: Fixed Point or Simple Range?
The final question posed by the RBI is whether to replace the current fixed midpoint of 4% with a simple target range, such as 3-6% . Central banks globally use different types of targets :
Point Targets: A single number, like 2%.
Point Targets with Tolerance Bands: A central point with an acceptable range of deviation (India's current model).
Target Ranges: The entire range is the objective, with no specific midpoint.
The central bank's discussion paper cautions against abandoning the fixed midpoint in favor of a simple range. The RBI argues that this move could be seen as a "weakening of the commitment to price stability" . Such a change could erode policy credibility with both domestic and international investors, who have come to trust the current, clear framework .
The following table provides a summary of the key debates surrounding the 2026 review.
Table 2: Key Debates for the 2026 Review
V. The Global Context and Emerging Challenges
A. Lessons from Around the World
India's adoption of the FIT framework places it within a larger global movement of central banks seeking a robust strategy for maintaining price stability . This strategy emerged as a new "nominal anchor" after previous approaches, such as monetary targeting and fixed exchange rates, proved to be unstable or too restrictive .
A number of countries with a history of relatively poor inflation performance were among the first to adopt this framework . New Zealand was the pioneer in 1989, followed by Canada in 1991, the United Kingdom in 1992, and Australia in 1993 . These countries, like India, chose a flexible approach that provides a clear, long-term goal while allowing for discretion in managing short-term shocks .
A comparison of frameworks reveals that India's model is consistent with global practice. As the RBI's discussion paper notes, almost all inflation-targeting countries have chosen headline CPI as their target, regardless of their stage of development . This global consensus reinforces the validity of India's current framework.
The table below offers a comparative view of inflation targeting frameworks in selected countries.
Table 3: Inflation Targeting Frameworks in Selected Countries
B. A Look to the Horizon
While the FIT framework has performed well, the RBI's discussion paper highlights that the future of monetary policy will face even greater challenges due to a new set of emerging risks . These risks include "geo-economic uncertainties, volatility of commodity prices, climate change and innovations in payment systems" .
Another important factor is the outdated CPI base year of 2011-12 . While the RBI's position is that the continued dominance of food in Indian households' consumption basket justifies the current framework, a new base would likely reduce the weight of food, which could influence future policy decisions . This ongoing review provides a critical opportunity to ensure the framework is well-prepared to navigate these evolving complexities and continue its success in the years ahead.
VI. Conclusion: Reinforcing the Commitment to Price Stability
The Flexible Inflation Targeting framework has been a significant success for India, providing a stable, credible anchor for the economy's monetary policy. The evidence is clear: the framework has demonstrably reduced both the average level and volatility of inflation since its adoption . The success of the framework is not limited to periods of stability; it has been a guiding force in navigating unprecedented shocks, from the COVID-19 pandemic to the Russia-Ukraine war, by allowing the central bank to appropriately balance the objectives of price stability and growth .
In its discussion paper, the RBI has presented a robust and well-reasoned case for continuity, arguing against radical changes that could undermine the credibility and hard-won gains of the last nine years . The central bank's strong defense of retaining headline CPI, the 4% midpoint, and the ±2% tolerance band is not born of a reluctance to change, but rather from a careful, data-backed assessment of what works best for the unique socio-economic context of a large, fast-growing economy .
The consultative process that the RBI is undertaking demonstrates its commitment to a transparent and deliberative approach. By inviting feedback from a wide range of stakeholders, the central bank is ensuring that the framework for the future is not only technically sound but also enjoys public support, which is the ultimate foundation of its authority. The conclusions of this review will be crucial for reinforcing India's commitment to price stability and preparing its monetary policy for the challenges and opportunities of the future.
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