India should continue with its flexible inflation targeting framework

Continuing with the FIT framework will ensure policy certainty in these uncertain times

The Reserve Bank of India (RBI) has done well to release a discussion paper on the review of the monetary policy framework, seeking feedback on four key questions. The RBI Act was amended in 2016 to provide the legal foundation for adopting the flexible inflation targeting (FIT) framework. The Act gave the RBI a clear mandate to “maintain price stability, while keeping in mind the objective of growth.” Accordingly, it is expected to keep the inflation rate based on the consumer price index (CPI) at 4 per cent, with a tolerance band of two percentage points on both sides. The law also requires the Union government, in consultation with the RBI, to set the inflation target once every five years. The target, reviewed and retained in 2021, remains valid until March 2026, prompting the RBI to issue the paper.

 

The adoption of FIT is seen as one of the most significant reforms in recent decades. It provided the central bank with an explicit target, which enhanced policy transparency and improved communication significantly. Another important element of the framework is the Monetary Policy Committee (MPC). This six-member panel — with three members from the RBI, including the governor, and three external members —  determines the policy repo rate required to achieve and maintain the inflation target. The shift not only strengthened the policy decision-making process but also made it more transparent. Earlier, decisions on monetary policy were made by the RBI governor, which often invited criticism and led to tensions with the Union government. The record thus far shows that the MPC has taken more split decisions than unanimous ones, which is a healthy sign and underlines the robustness of the process. The views of all MPC members are also made public through the minutes of the meeting. Thus, the FIT framework is much more sound than the practice before its adoption. The RBI was often seen chasing multiple objectives with a single instrument — policy rates.

 

The FIT regime has been in operation for about nine years. The average inflation rate in this period was 4.9 per cent, compared to 6.8 per cent in the pre-FIT period (the current CPI series). The volatility in inflation has also reduced markedly during this period. It is worth noting that the inflation rate increased globally, including in India, following the pandemic, due to various factors. Thus, overall, there is not much debate on continuing with the framework. In fact, once adopted, no major country has ever abandoned inflation targeting.

 

The discussion paper has posed four important questions. First, is headline or core inflation the best guide for monetary policy? Second, whether the 4 per cent target remains optimal. Third, should the tolerance band be revised, and fourth, should the target be a range instead of a level of inflation? It would be interesting to see the kind of responses the RBI receives. Technically, as things stand, only the inflation target is due for review. Any other change will require an amendment to the Act. Nevertheless, the issues raised in the discussion paper are worth deliberating.

 

Ever since the adoption of the framework, the issue of targeting core or headline inflation has kept surfacing every now and then. The Economic Survey for 2023-24, for example, said that using short-run monetary policy tools to deal with inflation emanating from supply constraints could be counterproductive. However, as has been argued by many, including the top brass of the RBI on various occasions, households see the overall increase in the price level, and expectations are more aligned to the headline rate. Removing food, for example, which constitutes about 46 per cent of the consumption basket, can undermine policy credibility. Given the weighting of food in the CPI, the government also often intervenes to address supply-side issues, though such interventions have other implications. Besides, globally, all inflation-targeting central banks look at the headline rate, except Uganda. Therefore, there are strong reasons for continuing with the headline rate.

 

Similarly, the target of 4 per cent and the two percentage point tolerance band were chosen after careful consideration and analysis of empirical evidence. Unless there is a visible shift in the requirements of the economy, it will make sense to continue with both the target and the tolerance band. According to RBI research, 4 per cent is the desirable rate of inflation for India. As the discussion paper notes, over time, some countries have narrowed the tolerance band. It would be desirable to reduce the band to induce more certainty in the policy framework at an appropriate point in future.

 

For now, given the large food component in the CPI, it would be wise to continue with the present tolerance band. As the share of food comes down in the consumption basket over time with overall economic development, volatility in inflation outcomes would reduce. A new CPI series is expected to start early next year. Finally, opting for a range instead of a point target could create both policy formulation and communication challenges, potentially undermining credibility. Therefore, at this stage, there is no compelling reason or evidence to modify the FIT framework. Continuing with it for now will also ensure policy certainty in an economic environment that is becoming increasingly uncertain.