GS Paper 3- Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment
Introduction
Flexible Inflation Targeting (FIT), adopted in 2016, mandates the RBI to maintain Consumer Price Index (CPI) inflation at 4% ± 2%. As the framework comes up for review in 2026, key questions regarding the optimal target, inflation band, and the relevance of headline versus core inflation have come to the forefront.
Inflation Control as a Policy Priority
Inflation control remains a central monetary policy objective. High inflation acts as a regressive consumption tax, disproportionately hurting poorer households, eroding savings, discouraging investment, and creating macroeconomic uncertainty.
Post the dismantling of automatic monetisation in 1994, RBI gained greater operational autonomy, culminating in the adoption of FIT in 2016. Since then, inflation has remained largely range-bound despite global shocks, underscoring the resilience of the framework.
Headline vs Core Inflation debate
A key debate is whether monetary policy should target headline inflation (full CPI) or core inflation (excluding food and fuel). Arguments favouring core inflation assume food prices are driven by supply shocks beyond monetary control. However
- Food inflation is not entirely supply-driven; expansionary monetary conditions tend to amplify it.
- Inflation ultimately reflects excess liquidity, not isolated price spikes.
- Second-round effects are strong in India, where rising food prices raise wages and production costs.
Thus, headline inflation better captures pressures affecting household welfare and macro stability.
Appropriate Level of Inflation
Post-1991 empirical analysis shows a non-linear growth-inflation relationship with an inflection point near 4%. Inflation beyond 4–6% significantly reduces growth. Forward-looking estimates (2026–2031) also place India’s optimal inflation target around or slightly below 4%.
Determining the Acceptable Level of Inflation
The classic Phillips Curve trade-off between inflation and growth is now widely accepted to be short-run only. For India, post-1991 data shows a non-linear relationship between inflation and growth, with the inflection point near 3.98%:
- Inflation up to around 4% is growth-neutral or mildly supportive.
- Inflation above 4–6% significantly reduces growth.
Forward-looking simulations for 2026–2031 indicate that an acceptable inflation target should remain around or slightly below 4%. There is little justification for raising it.
Conclusion
The FIT framework remains appropriate for India. A target around 4%, with the existing ±2% band and headline inflation as the primary anchor, strikes the right balance between flexibility and stability. Sustained monetary–fiscal coordination will be essential to preserve credibility, protect vulnerable households, and support durable economic growth.
Question– Critically analyse the effectiveness of India’s Flexible Inflation Targeting (FIT) framework and examine whether the current target of 4% ± 2% remains appropriate in the upcoming 2026 review
