Is India's inflation targeting too rigid for this oil-shock climate?

A credible framework requires credible measures of price expectations

There is little doubt that India’s inflation-targeting framework succeeded in reducing inflation. Before its introduction, India faced persistently high inflation, negative real interest rates, and recurring macroeconomic instability. The inflation rate often neared double digits, hurting household savings and creating uncertainty for investors. The post-inflation-targeting period has been markedly different, with lower inflation and greater monetary-policy credibility. Any serious discussion must begin by acknowledging this success. 

But success should not prevent us from recognising a growing weakness. Have these gains come at the cost of excessive growth sacrifice? Unfortunately, the answer is “yes”. The problem is rigidity. In an economy in which food prices are volatile and driven by geopolitics, and future inflation is difficult to measure reliably, targeting inflation based largely on past reported numbers can make monetary policy dangerously pro-cyclical, amplifying rather than stabilising business cycles. 

The fundamental problem is that reported inflation reflects the past while interest rates affect the future. For instance, the latest inflation figure for April measures price changes between last April and this April. But the real interest rate relevant for investment depends on future inflation. As a result, the Reserve Bank of India (RBI) often discovers the true real interest rate only after the fact. This makes actual real rates extremely volatile if the RBI’s decision making is based on reported inflation.

The first major example of this problem emerged soon after inflation targeting was introduced. India’s forward-looking real policy rate between 2015-16 and 2018-19 turned out to be close to 3 per cent, among the highest in the world. This occurred when the banking system itself was in crisis. Public-sector banks were burdened with stressed assets, credit growth had weakened sharply, and lending spreads had risen. Borrowers, therefore, faced double tightening: Higher spreads from banks and extremely tight monetary policy. 

This approach ignored a key lesson from the global financial crisis: Policy rates cannot ignore financial conditions. What matters is the effective borrowing cost. When banking stress pushes spreads up sharply, the neutral policy rate itself should fall. In fact, the modified Taylor Rule explicitly incorporated financial spreads and credit conditions. Yet in India, real policy rates remained high even as the banking system weakened and non-banking financial companies (NBFCs) entered a period of crisis. The framework remained excessively focused on reported inflation while underestimating deteriorating financial conditions.

The outcome was predictable. Growth slowed sharply and fell below 4 per cent in 2019. Inflation targeting succeeded in reducing inflation, but it also imposed very high borrowing costs during one of the weakest credit environments India had faced in decades. Assessing the framework’s success without accounting for the resulting growth sacrifice is therefore economically misleading. 

The same pattern repeated after Covid, though this time inflation was driven largely by food and supply-side disruption rather than generalised overheating. As the inflation rate crossed the upper limit of the tolerance band, the RBI entered an aggressive tightening cycle and raised the repo rate to 6.5 per cent, arguing that real rates were not excessively high because reported inflation remained elevated. But this interpretation later proved misleading. The actual inflation rate for 2025-26 eventually collapsed to around 2 per cent, implying ex-post real interest rates close to 4 per cent, among the highest in the world. The monetary policy, which initially appeared only moderately restrictive, turned out to have been extraordinarily tight, keeping the rupee overvalued for an extended period and hurting India’s international competitiveness. 

Now a third episode may be unfolding in the reverse direction. Only months ago, commentators were celebrating a supposed “Goldilocks” phase of low inflation and strong growth. As the reported inflation rate fell below the 4 per cent target, the RBI began cutting rates again. But even before the Iran conflict intensified, warning signs were visible. Borrowing by state governments was rising sharply, partly driven by an increasingly entrenched freebie culture, open market operations were indirectly monetising government borrowing, geopolitical tensions were rising globally, and government bond yields had risen more than 60 basis points over the year despite lower short-term rates. Yet policy discussion continued to focus narrowly on current inflation prints. A forward-looking assessment would likely have concluded that inflation risks were not truly benign and that at least the last couple of rate cuts were premature. 

The Iran conflict has made the situation far more complicated. Oil prices could rise sharply, and the headline inflation rate may again cross the upper tolerance band. If that happens, there is a real danger that the RBI may once again react mechanically to reported inflation. Rates could be raised at precisely the wrong moment, kept high for too long, and only later discovered to have produced another episode of excessively tight real interest rates. 

This is the central problem with backward-looking inflation targeting in a volatile emerging economy. When inflation is driven by temporary food or fuel shocks, the key question should not simply be whether the inflation rate breaches 6 per cent. The more important questions are forward-looking: How much inflation reflects excess liquidity and rising expectations versus temporary supply shocks, how long the shocks will last, and whether inflationary pressures will persist beyond the initial disruption. These are ultimately judgement calls, especially in a country with limited high-quality data. 

None of this means India should abandon inflation-targeting altogether. Countries with histories of macroeconomic instability benefit from nominal anchors. But a credible inflation-targeting framework requires credible measures of inflation expectations. At present, inflation expectations in India are inferred largely from surveys, which often fail to reflect actual pricing behaviour. Spikes in food prices can temporarily inflate survey responses even when firms and long-term contracts do not adjust similarly, while temporary declines in the food inflation rate can mask persistent underlying inflationary pressures. 

India, therefore, needs much better ways of measuring expected inflation. Rental agreements, school-fee contracts, wage revisions, supplier agreements, and contracts with built-in price escalation clauses may provide better signals of future inflation than household surveys. Financial-market signals should also be used more systematically, and surveys need better calibration using actual outcomes and recent research on inflation expectations. More India-specific research on how inflation expectations are formed is urgently needed. 

Until then, competent and independent central bankers exercising judgement may be preferable to mechanical adherence to backward-looking inflation numbers.

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The author teaches finance at the Indian School of Business