Published on: November 15, 2025

FLEXIBLE INFLATION TARGETING

FLEXIBLE INFLATION TARGETING

Introduction

Inflation management is a cornerstone of macroeconomic stability. Since 2016, India has adopted the Flexible Inflation Targeting (FIT) framework, mandating the Reserve Bank of India (RBI) to maintain inflation at 4% ± 2%. As the current mandate ends in March 2026, the framework is under review. This essay evaluates key questions central to that review: (1) What to target—headline or core inflation? (2) What should be an acceptable level of inflation? (3) Is the existing inflation tolerance band adequate?

Importance of Controlling Inflation

  • Inflation as a regressive tax: High inflation disproportionately affects poorer households whose incomes are not indexed to price increases.

  • Impact on savings and investment: Persistent inflation discourages savings, distorts investment decisions, and undermines financial stability.

  • Historical perspective:

    • The Chakravarty Committee (1985) considered 4% as a reasonable inflation rate to allow necessary relative price adjustments.

    • Post-1994, with the dismantling of automatic monetisation, RBI gained greater autonomy, enabling better inflation management.

What Should Inflation Targeting Focus On? Headline vs Core

Why Headline Inflation Matters

  • True measure of cost of living: Headline inflation captures changes in all goods and services, directly affecting household welfare.

  • Protection of vulnerable groups: Food and fuel have high weight in poor households’ consumption baskets.

Misconceptions Around Core Inflation

  • Food inflation is not always supply-driven: Episodes show food prices also respond to expansionary monetary conditions.

  • Relative prices vs general price level:

    • Without excess liquidity, spikes in individual commodity prices do not raise the general price level.

    • However, in India, second-round effects—wage pressures and higher input costs—often transmit food price shocks into broader inflation.

Conclusion

Given India’s structure, headline inflation remains the most appropriate target to ensure welfare and macroeconomic stability.

Acceptable Level of Inflation: Is 4% Justified?

Phillips Curve Debate

  • The traditional Phillips Curve—trade-off between inflation and growth—has not held consistently.

  • Economists like Friedman argued that such a trade-off exists only in the short run.

Threshold Inflation Concept

  • Empirical studies show that beyond a certain level of inflation, growth suffers.

  • Recent analysis indicates that for India, the threshold lies near 4%, with the inflection point estimated at 3.98%.

Forward-Looking Considerations

  • Future macroeconomic conditions, fiscal pressures, and external vulnerabilities must inform the target.

  • Preliminary simulations suggest inflation below 4% may be optimal, but the currently mandated 4% remains reasonable.

Inflation Band: Is ±2% Adequate?

Merits of the Current Band

  • The 2%–6% range has provided adequate policy flexibility during global shocks.

  • It prevented inflation from spiralling while allowing growth support during crises.

Remaining Concerns

  • Persistent operation near the upper band undermines the credibility of the FIT system.

  • Empirical observations indicate that growth declines sharply beyond 6% inflation.

Fiscal-Monetary Coordination

  • India’s high inflation experience during the 1970s–80s was driven predominantly by monetised deficits.

  • The sequence of reforms—ending ad hoc treasury bills, enacting the FRBM Act, and adopting FIT—strengthened macroeconomic stability.

  • Any dilution of FRBM or FIT provisions risks destabilising the other.

Conclusion

Flexible Inflation Targeting has contributed significantly to anchoring inflation expectations in India. While the 4% target and ±2% band appear broadly appropriate, stronger commitment to headline inflation metrics and fiscal discipline is essential. A well-calibrated FIT framework, paired with credible fiscal consolidation, will ensure India’s sustained growth and macroeconomic resilience in the coming decade.

Mains Questions

  1. Discuss the rationale behind adopting a 4% inflation target under India’s Flexible Inflation Targeting framework. Is this level still appropriate? Explain.

  2. Should monetary policy target headline inflation or core inflation? Evaluate with reference to India’s economic structure.

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