India’s Inflation: A Decade On
Why in News?
Recently, India has just completed a decade of inflation targeting as a formal policy framework of the Reserve Bank of India. Under this framework, the RBI is supposed to contain inflation at 4% within a band of (+/-) 2 percentage points.
At the same time, a decade-long evaluation of India's FIT framework published in Economic and Political Weekly (EPW) has raised critical questions about its theoretical assumptions and real-world effectiveness in the Indian economy.
What is Inflation Targeting (IT)?
Inflation Targeting (IT) is a monetary policy framework where the central bank publicly announces an explicit quantitative target for the medium-term inflation rate. In India, it is 4% with a tolerance band of ±2%, under the amended RBI Act, 1934.
What is Flexible Inflation Targeting (FIT)?
FIT is an updated version of IT, which dealt with the monetary policy framework where the central bank uses interest rates to keep inflation within a specific, publicly announced target range while also keeping economic growth objective in mind.
Statutory Backing: New Zealand was first to adopt inflation targeting globally in 1990. India formally adopted FIT in 2016 following Urjit Patel Committee recommendations.
Section 45-ZA of the amended RBI Act, 1934, mandates the government to set an inflation target in consultation with the RBI every five years.
The Target & Anchor: India has retained a 4% retail inflation target (with a +/- 2% band) for the next 5-year period (1st April 2026 to 31st March 2031). The primary anchor used is the Headline Consumer Price Index (CPI-Combined) (with base year 2024).
Accountability Mechanism: If average inflation breaches the 2-6% tolerance band for three consecutive quarters, RBI is deemed to have failed its mandate and must submit a written report to the government explaining reasons and remedial actions.
Key points
India's 10-year Flexible Inflation Targeting (FIT) has brought average inflation down from 6.8% to 4.9%, but an EPW study shows the Phillips Curve is almost flat, and people still expect high inflation, which questions whether just raising interest rates to control demand really works. To make FIT stronger, India needs to combine monetary policy with supply-side steps, manage public inflation expectations better, improve how rate changes reach the economy, and handle food and fuel price shocks without hurting growth and jobs too much.
How Inflation Targeting Works?
RBI tries to control inflation through two main channels:
| Aggregate Demand Channel: | When inflation rises, RBI increases the repo rate. This makes commercial loan rates higher, so home and consumer loans become expensive. People and businesses delay spending and investment, which reduces overall demand and helps cool inflation. |
| Expectations Channel: | By fixing a clear target, RBI tries to control what people expect about future inflation. If people believe prices will stay stable, workers won't demand high wage hikes and businesses won't increase prices in advance, which stops inflation from rising on its own. |
What are the problems with the FIT Framework?
1. Flat Phillips Curve: Data from April 2012 to March 2026 shows India's Phillips Curve is almost flat. This means there is a weak connection between growth and inflation. So, sharp rate hikes can hurt output and jobs a lot but not reduce inflation much, which can even lead to stagflation.
2. Wrong assumption about wages: Traditional theory says when output rises, workers demand higher wages, which pushes up prices. But in India, about 92% of workers are in the informal sector with no bargaining power. They are just price takers, so this link between output and wage-driven inflation does not work here.
3. Unanchored expectations: Household inflation expectations have been consistently about 4 percentage points higher than RBI's own projections. This shows RBI has not been able to anchor public sentiment through the expectations channel.
4. Supply-side inflation: Indian inflation is mostly due to food price volatility, monsoon failures, fuel price changes, and global supply disruptions. Monetary policy is mainly a demand-management tool, so it cannot fix supply shortages directly. Without fixing supply issues, tight monetary policy may only reduce demand, output, and jobs without bringing inflation down sustainably.
5. High liquidity problem: RBI often must handle excess liquidity in the system, for example, from forex operations. This surplus liquidity pulls down overnight interest rates, which goes against RBI's tight stance to control inflation.
Arguments in favor of FIT
| Macroeconomic Stability: | Despite recent shocks, average inflation has come down significantly under FIT compared to the pre-2014 period, when CPI often stayed near 10%. Between 2016 and 2025, FIT performance was like an inverted U, and inflation stayed close to the 4% target in the first and last three years but moved towards the 6% upper limit in the middle period due to Covid-19 and the Russia-Ukraine war. Overall, average inflation fell to 4.9% after FIT adoption in 2016, compared to 6.8% before FIT. |
| Optimal growth level: | A recent RBI study (1991 to 2023, excluding Covid years) mapping the inflation growth curve found that India's growth is highest when inflation is kept near the 4% central target. |
| Institutional credibility: | With legal backing from the Monetary Policy Committee (MPC), RBI's independence has improved. It has helped stabilize market expectations and protected monetary policy from fiscal dominance. |
What measures are needed to improve FIT in India?
1. Create Joint Food Inflation Response Cell: Set up a joint mechanism between RBI and the Consumer Affairs Ministry. If food inflation crosses 6% for three months, it should automatically trigger buffer-stock release, sale of pulses, and cut in import duties. This will reduce pressure on MPC to raise rates for supply shocks.
2. Re-evaluate policy anchor: There should be continuous debate on whether to target Core Inflation (which excludes volatile food and fuel) instead of Headline CPI so that monetary policy is not disturbed by temporary farm-related shocks.
3. Strengthen rate transmission to the informal sector: Extend transparent benchmark-linked pricing to NBFCs and MFIs, and expand credit guarantees for MSMEs so that repo rate changes reach the informal economy, where transmission is weak.
4. Bring back retail inflation-indexed bonds: Reintroduce liquid, retail-oriented inflation-indexed bonds with regular interest payouts. This will give households a proper hedge against inflation and reduce dependence on gold.
5. Set clear second-round effect indicators: Define measurable conditions, like persistent food inflation along with a sustained rise in core inflation, to judge second-round effects before further tightening. This will make MPC decisions more predictable and reduce unnecessary cost to growth.
Conclusion
India's FIT framework has helped bring down inflation and maintain macro stability, but the EPW study shows its limits in an economy driven by supply shocks and a large informal sector. The way forward is not to abandon FIT but to reform it, combining monetary policy with supply-side measures, better expectation management, and stronger transmission, so that inflation is controlled without hurting growth and jobs.
