The RBI's monetary policy framework has worked well, change not required

The Reserve Bank of India (RBI) has released a discussion paper on the monetary-policy framework. As the second review of the flexible inflation-targeting regime approaches in March 2026, the central bank has opened the floor for discussion. The paper makes clear that the current framework, anchored to a 4 per cent target with a 2 percentage point tolerance band on both sides, has served the Indian economy well since its adoption in 2016. The trend-inflation rate has hovered close to the target, except mostly in times of excess volatility, and the credibility of the central bank has visibly strengthened. Household inflation expectations, which spiked during the pandemic, have since moderated. Yet, since the target is to be reviewed by the central government in consultation with the RBI every five years, it has done well to open the floor for a broader discussion. The paper poses four key questions for public feedback. First, whether the headline- or core-inflation rate (non-food, non-fuel) should guide monetary policy; second, whether the 4 per cent target remains appropriate; third, whether the 2 percentage point band remains suitable; finally, if the framework should stick to a fixed-point target or move to a range to provide greater flexibility. These questions go to the heart of balancing credibility with adaptability. 

On the first question, the paper’s reasoning is sound. To ignore the food-inflation rate in a country like India would be to ignore the welfare of millions for whom food expenditure is the dominant share of the household budget. The core-inflation rate may be less volatile, but the headline-inflation rate better reflects the cost of living. Moreover, international practice overwhelmingly favours the headline-inflation rate as the target metric, regardless of income levels or development stage. Uganda remains the exception among the inflation-targeting countries. For India, this rate must therefore remain the anchor. What is needed is a periodic review of the consumer-price index to better reflect household consumption. On the 4 per cent inflation target, it is worth remembering that it was chosen after much consideration. Raising the target risks being seen by markets as dilution of price discipline. No major central bank has increased the target in the recent past. Also, empirical evidence supports the 4 per cent target. Thus, it would make sense to stick to the target for a considerable period and build credibility before looking at the possibility of a change. 

On the third question of the tolerance band, the 2 percentage point band cushion has provided much-needed flexibility, especially in periods of supply shocks, such as the Ukraine war. The upper end is also determined by the threshold level of inflation, beyond which it becomes detrimental to growth. Several economies have narrowed the band over time. However, for India, given the volatility in food prices, it makes sense to retain the band for now. Finally, should the target itself be replaced by a range? A range would undoubtedly provide the RBI with more flexibility. But there is a danger that it might blur communication and affect expectations. For a country where inflation expectations have only recently been firmly tamed, credibility is best preserved by a point target, with the band serving as a practical margin for shocks. The experience of the past decade shows that inflation targeting has served India well, and it would be appropriate to continue with the existing framework until there is enough empirical evidence to suggest a need for change.