Flexible Inflation targeting, a good balance

Review of India’s Flexible Inflation Targeting (FIT) Framework

Background

• India’s Flexible Inflation Targeting (FIT) framework—targeting 4% inflation with a ±2% band—expires in March 2026.

  
  

• RBI released a discussion paper seeking views on:

  • Headline vs core inflation

  • Acceptable inflation level

  • Whether the inflation band should change

    
    

• Since adoption in 2016, inflation has remained largely range-bound, even during multiple shocks.

  
  

Why Inflation Control Matters

• High inflation acts as a regressive tax, hurting poorer households more.

  
  

• Persistent or volatile inflation:

  • Reduces real savings

  • Distorts investments

  • Weakens macroeconomic stability

    
    

• Historically, RBI strengthened inflation focus after ending automatic monetisation in 1994.

What Inflation Should RBI Target?

Headline vs Core Inflation

Arguments for Targeting Headline Inflation

• FIT’s aim is to protect consumers, savings, and investments; thus headline inflation better captures real price pressures.

  
  

• Assumption that food inflation is purely supply-driven is incorrect.

  • Food inflation is higher in expansionary monetary conditions.

    
    

• Indian data show second-round effects of food inflation on core inflation:

  • Pushes wages upward

  • Raises non-food prices

    
    

• As Milton Friedman noted, general price level rises only when money supply expands.

  
  

Key Insight

• Without increased aggregate demand, food inflation represents relative price changes, not general inflation.

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• But in India, food inflation spills over to core inflation.

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• Therefore, headline inflation must remain the target.

Acceptable Level of Inflation

Is 4% Still Reasonable?

• Earlier, the Chakravarty Committee suggested 4% as acceptable (reasoning unclear).

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• Phillips Curve-based arguments for a stable trade-off between inflation and growth do not hold in the long run.

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• Evidence from a non-linear relationship (1991–present, excluding COVID year):

  • Inflection point estimated at 3.98%

  • Suggests optimal inflation level ≈ 4%

    
    

• Preliminary forward-looking simulations for 2026–2031 also indicate acceptable inflation below 4%.

  
  

Conclusion

• Very limited justification to raise the inflation target above 4%.

  
  

Inflation Band: Should ±2% Be Revised?

Present Experience

• The ±2% band (i.e., 2%–6%) has given sufficient flexibility to monetary policy.

• Problem: framework does not specify how long inflation may stay near the upper limit.

• Persistently staying near 6% would violate the spirit of FIT.

  
  

Growth Implications

• Evidence shows sharp decline in growth when inflation exceeds 6%.

  
  

• Maintaining fiscal discipline is crucial:

  • Historically (1970s–80s), high inflation was driven by fiscal deficit monetisation.

    
    

• Post-reform era:

  • End of ad hoc Treasury Bills

  • FRBM Act strengthened fiscal discipline

  • FIT evolved as a natural complement

    
    

Key Point

• FRBM and FIT must work together.

• Weakening one destabilises the other and threatens macroeconomic stability.

  
  

Key Takeaways

• Headline inflation should continue as the target.

  
  

• Acceptable inflation = around 4%, with little justification for a higher target.

  
  

• Current ±2% band is adequate, but staying near the upper end must be avoided.

  
  

• Strong coordination between monetary policy (FIT) and fiscal policy (FRBM) is essential for stability.