Why changing inflation target is fraught with risks for RBI's future policy

The RBI has sought views on four key inflation-targeting issues. Maintaining the status quo is recommended, with the focus on creating conditions to consistently achieve the existing 4% target

The Reserve Bank of India (RBI) recently released a discussion paper (DP) setting out four key issues for public feedback on the numerical inflation target, which is due for review in March 2026. The issues are — whether to target headline or core inflation; the optimality of the 4 per cent inflation target; the tolerance band of +/- 2 per cent around the target; and whether to maintain a central target with a tolerance band or shift to a target range. The paper is well researched and follows a balanced approach to put all the four issues in proper perspective. These are examined below: 

Headline vs core inflation 

Core inflation excludes volatile food and fuel items, making it more amenable to monetary policy. However, the targeting of core inflation also raises two key issues. 

First, there is always a risk of persistently high food and fuel inflation spilling over to generalised inflation through a wage-price spiral, as the public begins to build higher food and fuel inflation into their expectations. This risk of ‘second-round effects’ necessitates monetary policy action, even if food and fuel inflation itself is not directly amenable. 

Second, the headline measure of inflation broadly captures the cost of living of a basket of goods and services consumed by a typical household. With food and fuel constituting 52.7 per cent of the consumption basket in India, core inflation cannot serve as a basis for the overall cost of living measurement. Such a measure of inflation for targeting will be meaningless and, hence, it would pose a huge communication challenge for the RBI. This challenge could accentuate if headline inflation and core inflation diverge significantly, as has happened often in India. Significantly, a sharp divergence between the headline and core measures of inflation was precisely the reason the Bank of Thailand abandoned the targeting of core inflation in 2015. Since headline inflation is simple to understand and easy to communicate, most central banks target headline inflation. 

Optimality of 4% inflation target 

The consumer price index (CPI) headline inflation in the flexible inflation targeting (FIT) regime averaged 4.8 per cent, breaching the upper tolerance level on 28 occasions (out of 106 months). Even core inflation averaged 4.9 per cent. There is, therefore, no case of reducing the inflation target as the economy will have to pay a higher price in terms of output loss or growth rate foregone in its efforts to achieve the lower inflation target. Before considering any reduction in the target, it is imperative to align headline inflation to the target on a durable basis.  Unlike Brazil, Indonesia, and Thailand, which have reduced the inflation target and are cited in the DP, India lacks a long track record of inflation targeting, has a much higher food weight in the CPI, and faces greater fiscal dominance. Furthermore, inflation has consistently undershot the mid-point of the range in Thailand, while it has mostly stayed below or close to the target in Indonesia in the last six years. 

Given the track record of inflation under the FIT regime and the history of inflation, one could argue for the inflation target to be raised. However, this, too, is not desirable as any attempt to raise the target now will send a wrong signal to economic agents that the RBI is weakening its resolve to maintain low inflation. This may unmoor inflation expectations and may make the task of achieving any higher inflation target as challenging as achieving the 4 per cent target now. Therefore, what is important is to create the necessary conditions to enhance the effectiveness of FIT through the following three actions: 

First, since these are still initial years of the FIT framework, it would be prudent to focus on the primary objective of inflation a little more, even if it causes a somewhat greater output volatility. This is the price worth paying to gain greater credibility as it will improve the trade-off between output and inflation variability later, when the RBI can be more flexible. Second, it is important to continue pursuing fiscal consolidation to reduce fiscal dominance. Third, the CPI series needs to be updated urgently to reflect the reduced weight of food items in the latest household consumption expenditure survey (HCES). Thereafter, the CPI series needs to be revised every three years now that the HCES will be conducted every three years. This will provide the RBI with greater manoeuvrability in the conduct of monetary policy. 

Tolerance band 

In the context of the current tolerance band, the following factors are relevant: 

First, tolerance bands are not hard targets that can never be breached. However, if a band is breached frequently, it raises concerns. In India, the band has been breached frequently (31 times in 106 months – 28 times at the upper level and three times at the lower).  Therefore, there is no case to narrow the upper tolerance level. This will lead to greater output loss, which is unwarranted when the economy is facing several global headwinds. Second, a narrower band can lead to instrument instability since the policy rate will have to be changed frequently to keep inflation within the band. Third, the serious challenge posed by repeated supply shocks due to climate change, too, requires enough flexibility as embedded in the current band.  

There is also no case to widen the current band, which is already larger than that of 0.5 and 1.5 per cent in most emerging market economies (EMEs), and widening it could undermine the credibility of the framework. 

Central target vs range 

The target range provides the central bank the flexibility to choose its own target within the range, which need not necessarily be the centre of the range. It also means that within the range, the central bank has its goal independence. However, the target range also poses several challenges. 

First, without a central target, it would be hard to explain the inflation objective to the public. This could undermine the anchoring role of inflation expectation, which is the core rationale for adopting FIT. 

Second, if the RBI operates at the lower edge of the range, there would be greater loss of output. On the other hand, if it operates at the upper edge of the range, it means it is willing to accept the cost of increased inflation. This itself could be a source of huge uncertainty and increased volatility, both in output and inflation. 

Third, two potential ranges, which could be thought of in the Indian context, are: 3-5 per cent and 4-6 per cent. However, both these ranges are highly problematic. Having a 3-5 per cent range when realised inflation has breached the 6 per cent upper tolerance level over 25 per cent of the time will be extremely challenging. Also, this range will constrain the flexibility of the RBI and will entail greater output loss. On the other hand, a 4-6 range will suddenly raise inflation expectations, thereby frittering away the benefits that have been achieved so far with the central target. This is because all along, the endeavour of the RBI has been to align the actual inflation with the 4 per cent central target. 

Fourth, shifting from a central target with a tolerance band to any target range would amount to a drastic change, which could raise doubts about the effectiveness of the FIT framework and damage its credibility. 

Fifth, there is no empirical evidence to suggest that the target range performs better than a central target with a tolerance band. Most EME central banks have adopted a central target with a tolerance band as it provides a better balance between flexibility and credibility. 

In conclusion, the FIT framework has performed reasonably well, despite several exogenous shocks. Maintaining the status quo, i.e., a 4 per cent target with a +/- 2 per cent tolerance band, is the best option to enhance the credibility of the framework. The focus should be on creating conditions to achieve the 4 per cent target on a sustained basis such as fiscal consolidation and revising the CPI series regularly. 

The writer is senior fellow, Centre for Social and Economic Progress, former executive director, Reserve Bank of India, and former member of the Monetary Policy Committee. The views are personal.