Reinforcing the Anchor: The Next Five Years of Inflation Targeting in India

by Rajeswari Sengupta and Ajay Shah.

The adoption of inflation targeting (IT) in 2015 marked a watershed in India’s monetary policy. It is a delight to look back to those dramatic weeks. For the first time since its establishment in 1934, the Reserve Bank of India (RBI) graduated from being a `temporary provision’, to a clear legal mandate to maintain consumer price index (CPI) inflation at 4 percent. This shift to a rule-based and transparent framework, with price stability as the explicit objective, strengthened the RBI’s credibility, and helped anchor household inflation expectations by reducing the importance of extraneous objectives.

After the Monetary Policy Framework Agreement, the statutory basis for IT was provided by the Reserve Bank of India Amendment Act (2016). In this, the government, in consultation with the RBI, must review the inflation target every five years. The precise text of this section is:

45ZA. Inflation target – (1) The Central Government shall, in consultation with the Bank, determine the inflation target in terms of the Consumer Price Index, once in every five years.

The next review is scheduled for March 2026. In preparation for this process that would be led by the government, the RBI has released a discussion paper seeking public feedback on four specific questions:

1. Whether headline inflation or core inflation would best guide the conduct of monetary policy, given evolving relative dynamics of food and core inflation and the continuing high weight of food in the CPI basket?
2. Whether the 4 per cent inflation target continues to remain optimal for balancing growth with stability in a fast growing, large emerging economy like India?
3. Should the tolerance band around the target be revised in any way including whether the tolerance band be narrowed or widened or fully done away with?
4. Should the target inflation level be removed, and only a range be maintained within the overall ambit of maintaining flexibility without undermining credibility?

Targeting headline vs. core inflation

A substantial body of academic research and cross-country evidence informs the debate on whether central banks should target headline or core (excluding food and energy) inflation (Pandey and Patnaik, 2020). Walsh (2011) shows that in low-income economies, food inflation is more persistent than non-food inflation, with shocks to food prices spilling over into non-food prices. In such contexts, an exclusive focus on core inflation risks mis-specification. Empirical studies further document sizeable second-round effects from headline to core inflation, driven by the high share of food in household expenditure and the role of food inflation in shaping expectations and wage-setting (Anand, Ding, and Tulin, 2014).

The core function of monetary policy in this context is not to control the first-round effects of a supply shock (e.g., a poor monsoon), but to prevent them from propagating into generalised inflation through second-round effects on wages and expectations. This would be best achieved by having a credible central bank that fully devotes all the power of monetary policy to the pursuit of one transparent objective, headline inflation.

The Indian case illustrates these dynamics clearly. Food and fuel account for half of the household consumption basket, so excluding these components would eliminate a large share of relevant prices from the inflation measure. The Urjit Patel Committee Report (RBI, 2014) underscored that elevated food and energy inflation typically translates into higher inflation expectations, with lagged effects visible in services and other components. Moreover, shocks to food and fuel prices have larger and more persistent effects on inflation expectations than shocks to non-food, non-fuel items. Since anchoring expectations is central to the success of inflation targeting, a framework that sidelines food and fuel inflation would be incomplete.

The cross-country evidence reinforces this conclusion. As documented by Pandey and Patnaik (2020), most inflation-targeting economies use headline inflation as their target. A few, such as Thailand, initially targeted core inflation but later shifted to headline inflation in recognition of its greater relevance for households and firms.

Headline inflation has further advantages. It reflects the cost of living most relevant to households, shaping both their consumption and investment decisions (including choices between financial assets, gold, and real estate). It also serves as the benchmark for firms’ price-setting behavior. Since monetary policy ultimately seeks to anchor public expectations, and central bank accountability operates through the political system, credibility depends on targeting the measure most salient to the public.

For these reasons, despite the argument that much of CPI inflation lies outside the direct influence of monetary policy, excluding food and energy would not yield a meaningful measure of inflation for policy purposes. While monetary policy cannot influence a poor monsoon, it is the only tool capable of preventing the resulting food price shock from de-anchoring inflation expectations and triggering a wage-price spiral. Targeting headline inflation forces the Monetary Policy Committee to remain vigilant against these second-round effects, which is the essence of a credible IT framework. Therefore, headline inflation remains the most feasible and appropriate target for the conduct of monetary policy in India.

The 4 percent inflation target

The inflation target should remain at 4 percent. Raising it would risk eroding public confidence in the RBI’s ability to control inflation, un-anchoring expectations and undermining the credibility of the framework. From a public debt management point of view, an unanticipated increase in the inflation target is tantamount to a partial debt default. Indeed, higher targets and wider bands are associated with greater output and inflation volatility (Horvath and Mateju, 2011).

Conversely, a reduction to 2 percent would only be feasible once India’s financial system is sufficiently developed to operate with limited policy space near the zero lower bound – a condition still many decades away. The sequencing there lies in first getting up to FSLRC level financial economic policy, having it stabilise for about a decade, and then examining the possibility of going down to a 2% target. This is perhaps 25 years away.

Tolerance band around the 4 percent target

The literature broadly agrees that price stability corresponds to an inflation of 1-3 percent in advanced economies, while for emerging economies the relevant range is 4-5 percent (RBI, 2014). Empirical estimates for India place the growth-impeding threshold of CPI inflation at 6 percent. Accordingly, the 1-3 percent benchmark for advanced economies provides a lower bound, while 6 percent marks an upper bound for India. As explained in the Urjit Patel Committee Report, this rationale underpinned the adoption of a 2-6 percent tolerance band under India’s inflation-targeting regime.

The principal merit of a band is that it allows a central bank that possesses a weak monetary policy transmission to have failures on meeting the inflation target without a loss of credibility. Back in the 2013-2015 period, there was a `learn to walk before you can run’ reasoning around this: it was a fully new idea, that RBI should target inflation, so it was better to start with an easier objective.

Having operated within this framework for a decade, the RBI has established a minimally viable inflation-targeting regime. The logical next step would now be to narrow the band to 3-5 percent, which would strengthen credibility and inspire greater public confidence than the relatively wide 2-6 percent range. Critics may argue that a narrower band increases the risk of a technical breach, potentially harming the RBI’s credibility. However, after nearly a decade of experience, the institution should possess the maturity to manage this tighter constraint and, if a breach occurs, to communicate its causes effectively to the public. The credibility gains from signaling a stronger, more precise commitment to the 4 percent target outweigh the communication challenges of a potential supply-shock-driven breach. It shows progress; it signals a move from a nascent to a mature IT regime; it enhances respect for India’s continued progress towards better institutions.

Range vs. Point target

Point targets with tolerance bands provide clarity and precision, while their symmetry conveys that the central bank seeks to avoid both deflation and inflation (Hammond, 2012). By contrast, pure range targets risk signaling weaker control over inflation. Consistent with this, most inflation-targeting countries adopt a point target with a tolerance band (Pandey and Patnaik, 2020). For households, moreover, a single, well-communicated number aids planning and decision-making, reinforcing the value of a widely recognized 4 percent target. When wage raises are being planned, we need for decision makers to not look at current and future inflation, but instead think that a 4% nominal wage hike is a 0% real wage hike.

Conclusion

Since its adoption in 2016, inflation targeting has enhanced the RBI’s monetary policy credibility (Garga, Lakdawala and Sengupta, 2024). Since its adoption, the IT framework has been a crucial institutional anchor for India’s macroeconomic stability. The forthcoming review is an opportunity not to question its fundamental design, but to reinforce it. Maintaining the 4 percent headline target while narrowing the tolerance band to ±1% would signal a confident evolution towards a more mature and credible monetary policy, safeguarding the hard-won gains in anchoring public expectations.

References

Anand, Rahul, Ding Ding, and Volodymyr Tulin (2014) Food Inflation in India: The Role for Monetary Policy, IMF Working Papers 14/178; International Monetary Fund.

Garga, Vaishali, Aeimit Lakdawala and Rajeswari Sengupta (2024) Assessing Central Bank Commitment to Inflation Targeting in Emerging Economies: Evidence From India,Working Papers 107, Wake Forest University, Economics Department.

Hammond, Gill (2012) State of the art of inflation targeting,Handbooks 29; Centre for Central Banking Studies, Bank of England.

Horvath, Roman and Jakub Mateju (2011) How Are Inflation Targets Set?In: International Finance 14.2, pp. 265-300.

Pandey, Radhika and Ila Patnaik (2020) Moving to Inflation Targeting NIPFP Working paper 316, August 2020.

Walsh, James P (2011) Reconsidering the Role of Food Prices in InflationIMF Working Papers 11/71; International Monetary Fund.

The authors are researchers at IGIDR, Bombay and XKDR Forum, Bombay, respectively.

Source: https://blog.theleapjournal.org/2025/09/reinforcing-anchor-next-five-years-of.html