Inflation targeting and the test of credibility

Syllabus: Indian Economy

Source: IE

Context

The Reserve Bank of India (RBI) released its discussion paper (August 2025) on reviewing the flexible inflation targeting (FIT) framework. With the current 4% CPI target within a 2–6% tolerance band expiring in March 2026, the RBI has cautioned that raising the target could dilute credibility and reverse policy gains.

Rationale for Retaining the 4% Target

• Credibility with Global Investors: Raising the target could be read as tolerance for higher inflation, weakening policy reputation. The recent S&P Global upgrade to BBB highlighted RBI’s inflation management as a pillar of investor confidence.

• Institutional Stability: The framework has built confidence in the MPC process and fiscal responsibility norms.

• Domestic Outcomes: Headline CPI inflation has largely stayed within the 2–6% band since 2016, reflecting policy success. The July 2025 figure of 1.55%, the second-lowest since the series began, is evidence of stability.

• External Balance: Low and stable inflation protects the rupee, maintains external competitiveness, and prevents erosion of capital inflows.

Headline vs. Core Inflation Debate

• Survey Argument (2023–24): Suggested targeting core inflation (excluding food and fuel), since food inflation is mostly supply-driven and outside the RBI’s control.

• RBI’s Counter: Persistent food price shocks spill into wages, rents, and mark-ups, affecting core inflation in the long run. Hence, headline CPI cannot be ignored.

• Global Norm: Nearly all inflation-targeting countries (advanced and emerging) use headline CPI; Uganda is the only one using core inflation.

• Indian Reality: With food accounting for almost 50% of the CPI basket, excluding it would weaken policy relevance for households and workers.

Key Issues in the Framework

• Target Level: Lowering below 4% is unsuitable for India’s growth needs; raising above 4% could erode institutional credibility.

• Tolerance Band: Debate exists on whether to keep the 2–6% band, narrow it, or remove it altogether. A band offers flexibility but can reduce accountability.

• Volatility in Inflation: Between 2014–2025, CPI inflation ranged between 1.5% and 8.6%, largely due to food price swings, while core inflation remained more stable.

• Policy Certainty: The framework has provided consistency, helping India withstand shocks like the pandemic and oil price surges without runaway inflation.

Positive Outcomes of the Framework

• Anchored Inflation Expectations: Households and firms have adapted decisions around a credible 4% anchor, reducing uncertainty.

• Improved Sovereign Ratings: Agencies like S&P Global have upgraded India, citing RBI’s success in keeping inflation broadly within the 2–6% band.

• External Stability: Low inflation has strengthened the rupee, stabilised foreign capital inflows, and supported current account management.

• Investor Confidence: Predictable inflation management reduces risk premiums on Indian assets, encouraging FDI and portfolio inflows.

• Resilience to Shocks: Despite global supply disruptions, India avoided runaway inflation, showing the framework’s effectiveness in turbulent times.

Way Forward

• Retain 4% Target: Raising above this could be viewed as dilution of policy; RBI stresses keeping it unchanged to preserve credibility.

• Do Not Lower Below 4%: A lower target could unnecessarily constrain growth in a developing economy like India.

• Continue Headline CPI: Food inflation has long-run spill overs into core; targeting only core would ignore household realities.

• Review Tolerance Band: Debate on whether to maintain, revise, or drop the 2–6% band continues; RBI advises caution against disrupting tested elements.

• Preserve Policy Certainty: Continuity in the framework is crucial in a time of geopolitical and economic uncertainty, ensuring India’s gains in fiscal responsibility and external stability are not eroded.

Conclusion

The inflation targeting framework has anchored prices and strengthened India’s economic credibility since 2016. RBI’s paper makes clear that the 4% anchor, headline CPI focus, and tolerance band remain essential. Fine-tuning may be considered, but continuity and credibility must guide the framework’s renewal in 2026.