Tamed prices, tight leash: The hidden cost of India's inflation win

The Reserve Bank of India’s (RBI’s) decision to seek public comments on its inflation-targeting framework is welcome. Consultation is healthy — but before making changes to the framework, we should first ask: How well has the regime worked?

 

The RBI’s discussion paper (August 2025) declares flexible inflation targeting (FIT) a success. It notes that average inflation fell from 6.8 per cent pre-targeting to 4.9 per cent afterwards, with the pandemic and Russia-Ukraine shocks pushing it up temporarily. Overall, the RBI concludes that FIT has served India well.

 

To judge how well FIT has worked, we must first ask how inflation was lowered. There are essentially two routes to lower inflation: The hard way — keeping real rates high long enough to restrain demand and credit — and the smart way — anchoring expectations so inflation declines with smaller output losses. Expectations typically anchor only after credibility is earned through consistent, firm action. As the discussion paper says, India’s numbers do show disinflation. The harder question is which route the RBI followed. Did inflation fall because expectations were credibly anchored — the “smart” path — or because real rates were kept high — the “hard” path?

 

If FIT worked as intended, expectations would be stable around 4 per cent even when actual inflation moves. The test is whether expectations have decoupled from realised inflation. They have not.

 

Another force was fiscal consolidation. Lower deficits and prompt supply-side actions helped stabilise prices — and, notably, fiscal discipline was maintained even through election cycles, a rare feat. This steadiness matters for credibility: It signals that price stability is a shared goal, not just a monetary task. Coordination matters — low inflation is easier when fiscal policy is aligned. A credible nominal anchor is reinforced, not replaced, by steady fiscal settings.

 

The RBI’s own surveys show that households extrapolate from recent experience. A 2024 study published in the RBI Bulletin by Michael Debabrata Patra, Joice John, and Asish Thomas George finds that food-price shocks spill over into expectations. My research with city-level RBI data, co-authored with Nishant Kashyap of IIM Ahmedabad, reaches a similar conclusion. Even after FIT, a one percentage point rise in current inflation lifts expected inflation by roughly 0.35 percentage points. Expectations continue to chase realised inflation rather than settle near 4 per cent.

 

Because expectations remain unanchored, the central bank has leaned on the blunt instrument of high real interest rates. Real rates rose materially after FIT. Monetary policy became more powerful — and costlier for growth: Inflation’s sensitivity to policy increased, but output fell faster for a given tightening. Disinflation arrived via tighter real rates, not better credibility. India may have achieved similar outcomes without a formal targeting regime, simply by maintaining tight real rates. For the same reason, the post-FIT average near 4 per cent should not be read as India’s natural inflation rate — it was achieved under sustained hard targeting. Estimates based only on the post-FIT sample are mechanically conditioned by the regime and will overstate how “natural” 4 per cent is. 

Why, after nearly a decade of targeting, have expectations not anchored? Three reasons stand out. First, Indian consumption baskets are unusually exposed to volatile food and fuel. Second, communication still fixates on the latest print more than the medium-term path. Third, measurement is weak: Surveys are subjective and noisy, and without forward-looking contracts or wage bargains, policy targets an unobserved variable. Three suggestions follow.

 

Measure expectations better: Policymakers should move beyond surveys and extract “revealed expectations” from actual contracts. Goods and services tax data on advance price commitments can show how far ahead prices are fixed and how often they are revised. This should be complemented with market-based gauges — indexed bonds and long-tenor yields — and used systematically, and transparently, in Monetary Policy Committee deliberations.

 

Do India-centric research on drivers of expectations: High-quality, India-specific evidence using contract-level data, household panels, and market indicators should test whether food-price movements dominate. If they do, credibility will be costly whenever monsoon shocks hit, and rigid inflation targeting may be a poor fit. If they do not, there is more room to build a durable anchor. Either way, the framework cannot be designed or evaluated on badly measured expectations, and the evidence base should be updated regularly.

 

Build flexibility into the framework: Until we measure expectations properly and understand what drives them, it is not possible to anchor them credibly. Insisting on a narrow point target forces monetary policy to carry the full burden and risks sacrificing growth when food prices spike. A wider band — say 3 to 6 per cent — would recognise structural volatility while preserving accountability. Once the expectations process is better understood and measured, the range can be tightened.

 

India’s inflation targeting has delivered lower inflation — but largely for the wrong reason. Rather than anchoring expectations, it has relied on high real rates, imposing larger growth costs. The ongoing review is an opportunity for course correction: Measure expectations with better data, deepen India-centric research on what anchors them, and adopt a more flexible band until we understand how expectations are formed in India. The destination remains the same — durable low inflation. The route must shift from brute force to credibility built on evidence, communication, and realism. 

 

The author teaches finance at the Indian School of Business. The views are personal