Why fine tuning inflation targeting is needed in India |ForumIAS

Source: The post Why fine tuning inflation targeting is needed in India has been created, based on the article “Fine-tuning ‘ inflation targeting’” published in “Bussiness Line” on 7 October 2025. Why fine tuning inflation targeting is needed in India.

UPSC Syllabus: GS-3-Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Context: The RBI’s discussion paper (2025) re-examines FIT, suggesting that while it should continue, it needs adjustment and flexibility to suit emerging-market realities.

Inflation Targeting (IT) is a monetary policy framework under which a central bank keeps inflation within a specified band to ensure price stability.
Flexible Inflation Targeting (FIT), adopted by India in 2016, allows balancing price stability with growth objectives.
- The concept of flexibility was initially derived from advanced economy models, but emerging economies need customised FIT frameworks due to higher exposure to external shocks.

Why fine tuning of FIT is needed

Historical inflation trends show that before FIT (1970–2014), average CPI inflation was around 8%, while post-FIT it fell to 5%. However, growth performance weakened, revealing a potential trade-off between inflation control and output expansion.
Despite large external shocks, CPI inflation has broadly remained around 4–6%, showing FIT’s success, yet frequent breaches above the target since 2018–19 call for recalibration.
Excess monetary tightening has proven counterproductive in the past, such as in the 1970s and 1990s, where high real interest rates coincided with low growth without curbing inflation.
High WPI inflation during 2021–23 did not transmit severely to consumer inflation because fuel price declines benefited consumers and firms, suggesting that headline inflation alone may not capture the full picture.
Supply shocks and commodity price volatility have become persistent, requiring flexibility rather than a rigid adherence to targets.
For emerging markets (EMs) like India, structural factors such as agricultural dependence, fiscal constraints, and energy imports make a more nuanced approach essential.

Key Recommendations

Adjusting FIT Parameters
1. Headline CPI should remain the primary target because it reflects the cost of living and affects household expectations. The target band of 4% ± 2% is appropriate but should be applied flexibly, allowing temporary deviations during supply shocks.
2. Policymakers should exercise measured discretion instead of adopting aggressive monetary tightening in response to short-term inflation spikes.
Preserving Flexibility and Discretion
1. The FIT framework should reduce arbitrary discretion while maintaining enough space for the Monetary Policy Committee (MPC) to respond to evolving conditions.
2. The composition and functioning of the MPC should ensure continuity and institutional memory, avoiding abrupt changes.
Improving Forecasting and Communication
1. Inflation forecasts should focus on month-to-month momentum rather than relying solely on base effects.
2. Independent academic forecasts should complement RBI projections to strengthen transparency and credibility.
3. Inflation indices must be rebased and updated periodically to reflect changes in consumption patterns.
4. Clear and transparent communication will help anchor market expectations and reduce volatility.
Enhancing Coordination with Fiscal and Structural Policy
1. Price stability depends not only on monetary policy but also on fiscal discipline and coordinated supply-side management.
2. The government must share responsibility for controlling food and fuel prices, which are key drivers of inflation.
3. Coordination between the RBI and the government can help mitigate pro-cyclical fiscal shocks.
Retaining Core Monetary Framework
1. The repo rate should continue to be the primary instrument of monetary policy.
2. The independence of the MPC must be maintained while ensuring predictability and transparency in decision-making.
3. Liquidity shocks should be addressed through targeted interventions rather than across-the-board tightening.
Diversifying Instruments for Emerging Markets
1. Emerging market central banks, including the RBI, should use a wider set of tools—such as liquidity operations, foreign exchange interventions, reserve management, and macroprudential measures to deal with multiple sources of shocks.
2. Maintaining durable liquidity during supply shocks is crucial to avoid financial stress.
3. Policymakers should avoid excessive dependence on the interest-rate channel alone.
Anchoring Expectations
1. Communication should use both headline and core inflation indicators to clarify the central bank’s stance.
2. In emerging markets, inflation expectations tend to adjust slowly; therefore, persistent communication and credibility-building are essential.
3. Policymakers should emphasise that inflation from temporary supply shocks does not represent a long-term trend.
Protecting Growth and the Poor
1. Low-income households are most vulnerable to high inflation and need protection through price stability.
2. However, maintaining low inflation must not come at the expense of growth and employment, which are equally vital for welfare.
Managing Supply Shocks
1. Explicit, pre-announced policy responses to global oil price movements can help stabilize expectations.
2. Targeted fiscal actions should complement monetary policy to address supply-side inflation rather than relying on rate hikes alone.
Maintaining Market Confidence
1. A credible, well-communicated, and flexible FIT framework enhances investor confidence.
2. Predictability and transparency in policy reduce risk premiums and borrowing costs for businesses and households.

Way Forward

India should retain the FIT framework but make it more adaptable to domestic and global challenges.
Forecasting accuracy must be improved using better models and data transparency.
Joint accountability between the government and the RBI should be institutionalized for handling supply shocks.
Public awareness campaigns can help align inflation expectations with the central bank’s objectives.
The FIT framework should be reviewed every five years to ensure its continued relevance and effectiveness.

Conclusion: India’s experience proves that inflation targeting works, but rigid application can harm growth. A fine-tuned, flexible FIT will better balance price stability, growth, and employment. Emerging economies must tailor FIT to their structural and institutional realities, using multiple tools, coordinated policies, and transparent communication to enhance macroeconomic stability. Thus, FIT should evolve into a context-sensitive, flexible discipline, anchoring inflation expectations while supporting inclusive growth.