Watershed moments: Introduction of RBI's flexible inflation targeting model

FIT model set to be reviewed amid call for excluding food inflation

For nearly three decades, India’s consumer price index (CPI) based inflation averaged close to 8 per cent, underscoring the limitations of its then-prevailing monetary policy framework, which relied on credit controls and a multiple-indicator approach. 

This system was increasingly seen as inadequate for anchoring inflation expectations or guiding macroeconomic stability.  Recognising the need for a more credible and structured regime, India introduced the Flexible Inflation Targeting (FIT) framework in June 2016. 

This reform followed amendments to the Reserve Bank of India (RBI) Act, 1934, which formally mandated the RBI to pursue price stability as its primary objective and established the Monetary Policy Committee (MPC) to set policy rates. The six-member MPC, composed of three RBI officials and three external members nominated by the central government, now takes interest-rate decisions through majority voting. In the event of a tie, the RBI Governor casts the deciding vote. 

The adoption of the FIT framework was motivated by persistently high inflation, which had reduced household purchasing power and contributed to macroeconomic volatility. 

The Urjit Patel committee — which was set up by the RBI and whose report was released in 2014 — highlighted the absence of a clearly defined monetary anchor and recommended inflation targeting to strengthen policy credibility. This led to the signing of the Monetary Policy Framework Agreement between the government and the RBI in February 2015. 

The inflation target — 4 per cent CPI-based inlfation with a 2-6 per cent tolerance band — was officially notified in August 2016.

The framework includes an accountability mechanism requiring the RBI to explain and outline corrective measures if inflation breaches the tolerance range for three consecutive quarters. The target itself is subject to a review every five years by the central government in consultation with the RBI. 

The FIT framework incorporates both discipline and adaptability. It aims to maintain medium-term price stability, and also allows for short-term responses to transient supply shocks. 

To support policy formulation under FIT, the RBI developed a Forecasting and Policy Analysis System (FPAS) and significantly enhanced its communication strategy. It now publishes MPC meeting minutes, member-wise voting records, monetary policy reports, and periodic inflation outlooks, improving transparency and enhancing public understanding of the policy stance. 

The credibility of the framework was tested during the Covid-19 pandemic and subsequent food price shocks. Instead of tightening monetary conditions indiscriminately, the RBI opted for targeted liquidity-support measures, seeking to preserve economic activity while anchoring inflation expectations. 

By April 2025, the headline CPI inlfation rate had moderated to 3.16 per cent, creating space for three repo rate cuts since February. 

In June, the RBI cut the repo rate by 50 basis points to 5.50 per cent and lowered the cash reserve ratio (CRR) by 100 basis points to 3 per cent. These decisions were supported by declining inflation trends, favourable monsoon projections, and a softening of food price pressures. 

The RBI is working to improve the operational efficiency of the FIT framework. Efforts are underway to enhance inflation-forecasting models, particularly in capturing food price trends, which are volatile and difficult to predict using conventional inputs. 

The central bank has begun integrating alternative datasets and machine learning-based techniques to improve forecasting accuracy and reduce policy lags caused by prediction errors. 

Gaura Sen Gupta, chief economist at IDFC First Bank, said that the FIT framework had been highly effective in enhancing the credibility of monetary policy by clearly defining a target for headline inflation. She added that the framework’s strength lay not only in its clarity but also in its built-in flexibility, which allows for temporary deviations from the target during periods of crisis through a tolerance band of ±2 percentage points around the 4 per cent target.“We expect the inflation target to be retained at 4 per cent, as it aligns well with India’s productivity differentials,” she said. She added that with climate change contributing to increased volatility in global food prices, maintaining the existing ±2 per cent band remains essential to allow policy flexibility during supply-side shocks.  

“We would recommend continuing to target headline inflation, as inflation expectations are closely tied to food prices,” she said. “Given the large weight of food in the CPI basket, monetary policy cannot ignore food inflation — even when it is primarily supply-driven.” 

Structural challenges to overcome 

Nevertheless, several structural challenges remain. Monetary transmission in India still lags international standards. While the share of repo-linked loans in retail credit has increased significantly, the pass-through to deposit rates is partial, dampening the full impact of rate reductions. Additionally, headline inflation often exceeds the upper bound of the target range due to supply-side shocks, particularly in food prices, limiting the RBI’s ability to continue easing. Some policy experts have suggested adjusting the target range or exploring a dual mandate that also gives weight to employment or output growth. Others have proposed focusing more on core inflation, which excludes volatile food and fuel components. Despite these debates, there remains broad agreement that headline CPI is the most relevant metric for assessing household inflation exposure. 

As the second statutory review of the FIT framework approaches in 2026, the RBI is considering a series of refinements, including improvements in liquidity forecasting, recalibration of open-market operations, and enhancement of forward guidance frameworks. RBI has consistently called for deeper coordination between fiscal and monetary authorities, especially during disinflationary periods, to ensure that macroeconomic instruments are aligned in purpose and timing. 

The Centre retained the inflation target and the tolerance band for the next five-year period — April 1, 2021, to March 31, 2026, after the first review. 

The review of the FIT framework assumes significance at a time when there is a call for excluding volatile food inflation from the target. Calling for a re-examination of the inflation-targeting framework, the Economic Survey last year said when food prices rise, inflation targets come under threat, which prompts the central bank to appeal to the government to bring down the increase in the prices of food products. This, in turn, prevents farmers from benefiting from the rise in prices. 

“Higher food prices are, more often, not demand-induced but supply-induced. Short-run monetary policy tools are meant to counteract price pressures arising out of excess aggregate demand growth,” the Survey said. 

The 2026 review is expected to evaluate whether the current framework has been effective in achieving its stated objectives of price stability and growth support. 

Potential adjustments — whether to the inflation target, the tolerance band, the composition of the MPC, or the scope of the RBI’s mandate — could have far-reaching consequences for the future trajectory of India’s monetary policy. Governor Malhotra has emphasised the importance of avoiding rigid adherence to the doctrine, instead advocating a pragmatic, evidence-based approach that supports economic stability while allowing the framework to evolve. As India enters this crucial phase, the FIT regime will undergo its first major test — one that will likely shape the future of the RBI’s institutional role in managing inflation and supporting sustainable growth.