Introduction

In 2016, India made a historic shift in its monetary policy framework by formally adopting inflation targeting (IT) through amendments to the Reserve Bank of India (RBI) Act, 1934. This framework established a medium-term consumer price index (CPI) inflation target of 4%, within a tolerance band of ±2% (i.e., 2% to 6%). It also institutionalised the formation of a Monetary Policy Committee (MPC) to determine policy interest rates. This collective, transparent, and accountable decision-making body marked a decisive move away from a centralised, discretionary approach. With the second quinquennial review of the framework scheduled for early 2026, the RBI has released a discussion paper to evaluate its performance and consider future directions.

Why Inflation Targeting?

India’s decision to adopt inflation targeting was rooted in a period of macroeconomic instability marked by persistently high inflation. Between 2010 and 2013, average CPI inflation hovered around 10%, eroding household purchasing power and complicating investment planning. Additionally, the absence of a clear nominal anchor led to uncertainty regarding the RBI’s policy priorities. The adoption of IT was intended to address this credibility gap. Globally, over 48 countries, including the United Kingdom, New Zealand, and Brazil, had already implemented similar regimes with notable success. For India, inflation targeting promised a structured mechanism to navigate the complex trade-offs between growth, price stability, and external vulnerabilities.

Key Achievements Since 2016

·       The IT regime has produced several positive outcomes. One of its most significant achievements has been price stability. Since 2016, average CPI inflation has moderated to approximately 4.9%, a marked improvement from the pre-IT average of 6.8% (RBI, 2024). Surveys indicate that inflation expectations among households and firms have begun to show signs of anchoring, a critical condition for macroeconomic stability.

·       The regime has also improved accountability. If inflation breaches the 2–6% tolerance band for three consecutive quarters, the RBI is legally required to report to the government, detailing the reasons, proposed remedies, and expected timelines for correction. This mechanism was activated in 2022 when inflation stayed above 6%, prompting the RBI to submit a formal explanation.

·       Transparency has improved substantially. The publication of MPC minutes, with individual member views released two weeks after each policy meeting, has enhanced the credibility and predictability of monetary policy decisions. Moreover, the IT framework has demonstrated flexibility during crises. During the COVID-19 pandemic, the MPC prioritised growth to support recovery, without completely disregarding inflation risks—thus maintaining a careful balance between economic stimulus and financial stability.

·       Institutionally, the IT regime has shifted decision-making from a “Governor-centric” model to a committee-based approach. This has introduced diversity of thought and greater policy deliberation, reflecting a more democratic structure.

Key Issues Highlighted in the RBI’s 2025 Discussion Paper

·       The discussion paper raises critical questions about the framework’s future. One such issue is whether the 4% target remains optimal for an economy like India’s, where structural factors—particularly food inflation—can create persistent upward pressure. While some suggest revising the target upward to accommodate such pressures, others warn that doing so could undermine policy credibility.

·       Another debate centres on whether the current model of a point target (4%) with a ±2% band should be replaced by a range-based system (e.g., 2%–6%), which might offer more flexibility in volatile conditions. However, such a shift could reduce the clarity of the policy anchor.

·       The paper also revisits the question of whether headline inflation, which includes food and fuel prices, should remain the target variable. Given the volatility of these components, some experts advocate for focusing on core inflation. Yet, the RBI maintains that headline CPI better captures the cost of living for households, particularly in a country where food and energy are significant parts of the consumption basket. Globally, most countries continue to target headline inflation, with Uganda being a rare exception in focusing on core inflation.

·       The width of the tolerance band is another area of scrutiny. Narrowing it (e.g., to 3–5%) could improve policy discipline but may constrain the RBI’s ability to respond to temporary supply shocks. Maintaining the existing band, therefore, provides a pragmatic balance between precision and flexibility.

·       Lastly, the RBI stresses that frequent revisions to targets or methodology risk weakening the credibility of the entire framework. Anchoring expectations requires consistency and long-term commitment to the chosen regime.

Global Experience with Inflation Targeting

Globally, inflation targeting has been widely adopted and retained. The United Kingdom, for instance, targets 2% CPI inflation but often overshoots due to global energy price shocks. New Zealand, the pioneer in IT since 1990, has modified its inflation range over time (from 0–2% to 1–3%) based on evolving economic conditions. Brazil’s approach reflects the volatility of emerging markets, incorporating a broader target band to allow for greater flexibility. Importantly, no major economy has abandoned the IT framework after adopting it, although adjustments and refinements have been common.

Criticism of India’s Inflation Targeting Regime

·       Despite its merits, the IT framework in India has not been without criticism. Detractors argue that it places excessive emphasis on inflation control at the expense of growth and employment, particularly problematic in a developing country with widespread poverty and unemployment. Moreover, much of India’s inflation is supply-driven—especially in food and fuel—areas over which monetary policy has limited influence.

·       There is also the issue of fiscal-monetary coordination. Expansionary fiscal policies, such as high deficits and untargeted subsidies, can counteract the RBI’s anti-inflation efforts. This conflict was visible during the pandemic, when large stimulus packages risked undermining inflation control.

·       Monetary transmission remains another challenge. Structural impediments, such as high levels of non-performing assets (NPAs), limited bond market depth, and slow rate pass-through by banks, reduce the effectiveness of policy rate changes. Critics also warn against policy rigidity, where a strict adherence to inflation targeting could result in pro-cyclical tightening during supply shocks, thereby worsening growth slowdowns.

Alternative Policy Frameworks Explored Globally

Alternative monetary frameworks have been proposed and trialled in various countries. Nominal GDP targeting, for example, captures both inflation and real economic growth, and has been recommended by some economists for India. The U.S. Federal Reserve follows a dual mandate—balancing price stability and maximum employment. India’s current model is best described as “flexible inflation targeting” (FIT), which attempts to incorporate growth objectives alongside price stability. Exchange rate anchoring, though considered elsewhere, is unsuitable for India given its high capital mobility and exposure to global trade volatility.

The Way Forward

·       The upcoming review offers India a chance to refine, rather than overhaul, its IT framework. Retaining the 4% inflation target is crucial for maintaining policy credibility. Any upward revision could risk unsettling markets and raising borrowing costs. The existing ±2% tolerance band remains appropriate, offering sufficient room to accommodate supply shocks without diluting policy focus.

·       Greater synergy between fiscal and monetary authorities is essential to ensure coordinated efforts in managing inflationary pressures. Improving monetary transmission is equally important and requires structural reforms, including deepening capital markets, accelerating interest rate pass-through, and cleaning up bank balance sheets.

·       Addressing supply-side inflation calls for investment in agricultural infrastructure, energy diversification, and logistics improvements. These long-term structural reforms can help reduce the frequency and severity of food and fuel-driven price shocks.

·       Credibility must be reinforced through consistent policy communication. The continued publication of MPC minutes and timely updates on inflation projections help guide market expectations. Clear, accessible communication from the RBI plays a pivotal role in managing public perceptions and fostering trust in monetary policy.

Conclusion

India’s adoption of inflation targeting in 2016 has significantly moderated inflation and strengthened the credibility of monetary policy. As the country prepares for the second five-year review in 2026, the challenge lies in preserving the benefits of the current framework while refining it to better address India’s structural and developmental realities. The RBI’s emphasis on “policy certainty and credibility” remains well-placed. A calibrated and adaptive approach—grounded in transparency, coordination, and institutional resilience—will be key to ensuring the regime’s continued success in a volatile global environment.