Context

• As India approaches the 2026 deadline for reviewing its Flexible Inflation Targeting (FIT) framework, currently defined as maintaining inflation at 4% ± 2%, the Reserve Bank of India (RBI) has initiated a substantive discussion on the future direction of monetary policy.
• Three core questions guide this review: whether policy should target headline or core inflation; what constitutes an acceptable level of inflation; and what the appropriate inflation band should be.
• Each issue has profound implications for macro­economic stability, household welfare, and policy coordination.

Inflation Control as a Policy Priority

• The foundation of the argument is the recognition that inflation control is an essential objective of monetary policy.
• High inflation operates as a regressive consumption tax, impacting poor households disproportionately, eroding real savings, discouraging investment, and generating economic uncertainty.
• The Chakravarty Committee had earlier suggested an acceptable rise in prices of about 4%, although the reasoning was not fully transparent.
• Since the dismantling of automatic monetisation in 1994, the RBI has enjoyed increased functional autonomy, culminating in the formal adoption of FIT in 2016.
• Since then, inflation has generally remained range-bound despite multiple external and domestic shocks. This stability underscores the success of a still-evolving framework.

Headline vs Core Inflation: What Should Monetary Policy Target?

• A persistent debate concerns whether policy should target headline inflation (total CPI) or core inflation (excluding food and fuel).
• The argument for targeting core inflation assumes that food inflation is driven mainly by supply shocks and is beyond the scope of monetary intervention.
• However, several observations contradict this view:
  • Food inflation is not always exogenous. During periods of expansionary monetary policy, food inflation tends to accelerate more strongly, indicating that monetary conditions matter.
  • General inflation arises from excess liquidity, not simply individual price movements. As Milton Friedman argued in his 1963 Mumbai lecture, inflation results when aggregate demand expands alongside money supply.
  • Indian data demonstrate second-round effects of food inflation, whereby rising food prices fuel increases in wages and input costs, eventually influencing the general price level if liquidity conditions permit.
• These dynamics reinforce the conclusion that headline inflation should remain the primary target of monetary policy.
• Doing so ensures broader protection for household welfare, prevents inflationary spirals, and aligns with the ultimate goal of price stability.

Determining the Acceptable Level of Inflation

• The question of an appropriate inflation rate intersects with the long-standing debate over the Phillips Curve.
• While early interpretations suggested a trade-off between inflation and growth, later theory and evidence, especially from Friedman and Phelps, established that any such trade-off is short-term and vanishes once expectations adjust.
• Empirical evidence for India since 1991 reveals a non-linear relationship between inflation and growth.
• A quadratic estimation finds an inflection point around 3.98%, implying:
  • Inflation up to about 4% may support growth.
  • Inflation above 4–6% harms growth significantly.
• Forward-looking simulations for the 2026–2031 period suggest that the acceptable inflation rate may lie slightly below 4%, assuming stable fiscal and external conditions.
• This indicates that there is little justification for raising the inflation target above 4%.

Reconsidering the Inflation Band: Adequacy of ±2%

• India’s current inflation band of 4% ± 2% has offered the RBI sufficient flexibility to navigate uncertainties.
• However, two issues deserve attention:
  • Duration near the upper limit matters. The framework does not specify how long inflation may remain close to the 6% upper bound. Prolonged stays near this limit risk undermining the credibility and intent of FIT.
  • Growth falls sharply when inflation exceeds 6%. Empirical patterns show that inflation above 6% correlates with a marked decline in growth, weakening any case for a wider band.
• The strength of the band is also tied to fiscal discipline. Historically, high inflation in the 1970s and 1980s stemmed from monetisation of fiscal deficits.
• Key reforms including the abolition of ad hoc treasury bills and the Fiscal Responsibility and Budget Management (FRBM) Act, curbed this risk.
• FIT logically follows from these reforms. Thus, FRBM and FIT must operate together. Weakening either framework would threaten macroeconomic stability.

Conclusion

• India’s review of the FIT framework represents a crucial opportunity to refine its approach to price stability.
• Headline inflation should remain the primary target, given its broader welfare relevance and demonstrated linkages with core inflation.
• An acceptable inflation rate of around 4%, or slightly lower, aligns with India’s empirical growth-inflation dynamics.
• The present ±2% inflation band provides adequate flexibility, but monetary authorities must avoid prolonged proximity to the upper limit to maintain credibility.
• Ultimately, India’s monetary–fiscal coordination, anchored through the FRBM Act and the FIT framework, remains essential for ensuring macroeconomic stability, safeguarding household welfare, and sustaining durable economic growth.