Rethinking India's Monetary Policy Framework: A response to the RBI Review

Former RBI Chair Professor Charen Singh says the 4 per cent inflation target stifles growth and jobs, calling for a flexible 5-7 per cent range and a band-only framework instead of a fixed point targe

India's monetary policy framework, centred on inflation targeting since 2016, is under review through a recent discussion paper released by the Reserve Bank of India (RBI). This regime mandates the RBI to maintain consumer price index (CPI) inflation at 4 percent with a ±2 per cent tolerance band. The review paper flags four critical issues: whether to focus on headline or core inflation, the appropriateness of the 4 per cent target, the necessity and width of the band, and whether to eliminate the target in favour of a band-only approach. These questions deserve serious attention.

 

Headline or core inflation?

 

For India, headline inflation is the correct focus. Core inflation excludes food and energy, assuming these are 'volatile' and therefore, less meaningful. But in India, food and energy dominate consumption patterns according to the weighting diagram of the CPI.

 

Indeed, much of India’s inflation volatility has been driven by onion, tomato, and potato (OTP). These supply-side products push inflation up but are temporary in nature and unrelated to monetary policy. In fact, raising repo rates cannot influence rainfall, logistic bottlenecks, production or hoarding by agriculture traders. Farmers neither plant nor hoard onions based on repo rates, nor do wholesalers adjust margins depending on the monetary policy signals.

 

Targeting core inflation, therefore, risks disconnecting policy from reality. Headline inflation, though imperfect in many ways, reflects what households actually face. It is also what influences wage demands, household savings, and political economy. For this reason, most countries target headline inflation, and India should continue to do so.

 

Is 4% an appropriate target?

 

The current 4 per cent target is too low for India’s context. A number of econometric studies, even those included in the review document of the RBI, have estimated India’s growth-compatible threshold inflation at 5.5–6 per cent and not 4 per cent. Even the simple 30-year average of inflation in India hovers around 6 per cent. 

The fixation of target with mid-point at 4 per cent as the primary objective can impose high sacrifice ratio — the output and jobs lost to suppress inflation below its natural threshold. This is especially costly for a young country where 62 per cent of the population is in the working-age group of 15 to 59 years. With only two more decades of demographic dividend available, every year of subdued growth implies millions of missed jobs.

 

In my experience, based on quick surveys with my students at IIM-Bangalore, people care more about employment than very low inflation. Families can "tighten belts" against inflation, as some of them told us, but cannot tolerate joblessness. For India, prioritising employment and growth is essential, and a 4 per cent target stifles both. A more realistic target in the range of 5–7 per cent range would align policy with ground realities.

 

Should there be a band?

 

A band is necessary, but it must be wide enough to provide flexibility. The current 4±2 per cent range (2–6 percent) is too tight for an economy vulnerable to supply shocks. Every time food or fuel prices push inflation beyond 4 per cent, the RBI feels compelled to tighten, even when monetary tools cannot address the underlying cause, mostly related to OTP or supply side challenges.

 

A more appropriate band, if necessary to impose, would be 5–7 percent. This reflects India’s inflation tolerance, avoids overreaction to OTP-driven spikes, and preserves space for growth. Importantly, the band should not be arbitrarily set but based on rigorous surveys of household tolerance, political economy, and empirical evidence on growth-inflation trade-offs.

 

Should the point target be removed?

 

Yes, the rigid point target should be replaced with a band-only framework. A fixed point like 4 per cent creates unnecessary rigidity and exposes the RBI to credibility risks when inflation, driven by supply shocks, repeatedly breaches it.

 

A band-only framework allows the RBI to maintain credibility while exercising discretion. It also aligns with India’s earlier Multiple Indicator Approach (MIA), pioneered by Governor Bimal Jalan and his deputy, Dr Y V Reddy during the Asian Crisis of 1997. The MIA framework considered money, credit, output, trade, fiscal indicators, capital flows, alongside inflation, exchange rate, and interest rate. The MIA helped India weather the global financial crisis of 2008 better than many economies.

 

By contrast, inflation targeting narrows the RBI’s focus and reduces its ability to respond to developmental priorities. A flexible band would restore balance and allow for pragmatic, context-sensitive policymaking and avoid rigidity in the policy.

 

Conclusion: Beyond the four questions

 

The RBI’s review paper has a narrow focus. It does not engage with the fact that India’s inflation is largely supply-driven, often by a few food items, and therefore less amenable to monetary policy. The sledgehammer of interest rates impacts the complete economy and therefore should not be deployed just because of OTP. It does not assess whether inflation targeting has delivered better outcomes than the MIA. And it does not confront the costs of targeting 4 per cent inflation in a young, employment-hungry country.

 

(The author is former RBI Chair Professor of Economics at the Indian Institute of Management-Bangalore)  (Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper)