India needs a serious debate on monetary policy and the impossible trinity

A foundational principle in international economics is the “impossible trinity” or “trilemma.” This asserts that a country cannot simultaneously maintain a stable exchange rate, allow full capital mobility, and pursue an independent monetary policy.

 

Putting inflation first: The January 2014 report of the Urjit Patel Committee shaped India’s monetary policy framework. The report recognised the trilemma and recommended giving precedence to flexible inflation targeting. It then emphasised the importance of allowing flexibility in exchange rate determination, while managing volatility through a combination of capital flow management (CFM) and macroprudential tools.

 

The report concluded that although international policy consensus was shifting towards multiple-target, multiple-instrument frameworks, India should first focus on reducing the then high inflation. The report noted that anchoring inflation expectations would eventually allow flexibility to pursue other objectives, without sacrificing price stability.

 

A clear nominal anchor — an inflation target — was proposed to discourage time inconsistency or discretion in policy, including due to pressures from interest groups.

 

Additionally, the report recommended that the Reserve Bank of India (RBI) build substantial foreign exchange reserves as a buffer against capital outflows. Fresh from the 2013 taper tantrum, the report also called for retaining flexibility for unconventional monetary measures, again reflecting the trilemma.

 

By March 2025, India’s total foreign exchange reserves (adjusted for outstanding forward sales) had more than doubled in absolute terms, compared to March 2013. However, in relative terms, the reserves were nearly the same at around 15 per cent of gross domestic product (GDP).

 

The MPC mandate: In June 2016, the RBI Act was amended. The preamble set the objective of monetary policy as maintaining price stability, while considering the goal of economic growth. The Act established a monetary policy committee (MPC) tasked with setting the policy rate to achieve an inflation target, which the government fixed at 4 per cent with a tolerance band of ±2 per cent.

 

Over time, the MPC has pursued an independent monetary policy, without reference to the external sector. As an example, the MPC’s statement on December 5, 2025, was silent about the external sector, despite USD/INR flirting with the psychological 90 level. Notably, the RBI’s discussion paper from August 2025 reviewing the monetary policy framework also does not mention the trilemma.

 

Currency market interventions: Officially, the RBI maintains that it does not target a specific USD/INR level and only intervenes to manage volatility. However, in practice, the RBI acts as a key player in absorbing large balance of payment surpluses and deficits, thereby influencing both prices and volatility.

 

Underscoring this, between FY2017-18 and FY2024-25, the RBI’s average annual net intervention in spot and forward markets exceeded $60 billion, over 2 per cent of GDP.

 

USD/INR market volatility offers further insight. From FY2017-18 to FY2021-22, average annualised daily volatility was 5.5 per cent, close to the 6 per cent annualised daily volatility of the DXY index (which tracks the US dollar against a basket of six major currencies). During this period, net investment capital flows into India averaged 1.7 per cent of GDP.

 

In contrast, between FY2022-23 and FY2024-25, annualised USD/INR volatility dropped to 3.3 per cent, even as DXY volatility rose to 7.4 per cent. USD/INR became significantly less volatile than other major currency pairs. Media reports attributed this to active RBI intervention that prevented INR depreciation, while dousing volatility. Notably, capital flows dropped to 0.6 per cent of GDP during this three-year period, pointing to the possible impact and constraint of the trilemma.

 

The mechanics of day-to-day market intervention should be left entirely to the RBI. However, opacity around the RBI’s medium-term currency policy has downsides for all stakeholders.

 

Should India always allow flexibility in USD/INR movements? While economic theory may favour letting currency markets adjust to changing fundamentals, there may well be strong arguments for active intervention under certain circumstances, even outside of political economy considerations. As an example, market participants warn of “reflexivity,” a phenomenon described by George Soros, where sharp market movements can themselves impact fundamentals adversely, creating a self-reinforcing cycle of instability. This is even more relevant given the integration of offshore non-deliverable forward (NDF) and domestic currency markets.

 

Currency market stability: We need an informed debate on determining under what conditions (if any), maintaining currency market stability might be deemed essential in the short run. This should be guided by objective criteria, perhaps linked to real effective exchange rate  and volatility, echoing the Urjit Patel report’s call to “disincentivise time inconsistency, including due to pressures from interest groups.” Note that in terms of the 36-country trade weighted real effective exchange rate, the INR is now the weakest it has been in many years.

 

If controlling currency market volatility is deemed desirable, monetary policy must be that much more nuanced. For example, if the immediate goal is to prevent a sharp INR depreciation, cutting policy rates may prove counterproductive, even if inflation and output gap projections allow for this. Lowering rates would reduce the interest rate differential with other currencies, making INR assets less attractive. This could lower USD/INR forward premia, encouraging importers to hedge, discourage exporters, and make speculation against INR cheaper. In fact, spiralling currency concerns could spur asset sales, and paradoxically, lead to higher bond yields.

 

Between FY2018-19 and FY2021-22, the USD/INR one-year forward premia averaged 4.3 per cent. Since then, it has declined to average 2.2 per cent. While this might seem justified given the narrowing inflation gap between India and the US, it can also encourage INR weakening.

 

Towards a nuanced debate: Given the impossible trinity, we need an informed debate on objective conditions under which financial stability and currency market could influence the conduct of monetary policy in the short run. The Urjit Patel report had suggested that well-anchored inflation expectations—now largely achieved — could eventually provide the flexibility to pursue other objectives without compromising price stability. Over the medium run, it would also be necessary to address the external balance by tackling the underlying fundamentals — namely, trade and capital flows.

 

This might make monetary and currency policy that much more nuanced, reflecting reality. Complexity in international economics cannot be wished or legislated away.

The author is a former whole-time member, Sebi.

The views are personal