Inflation Targeting
Inflation targeting is a monetary policy framework in which a central bank publicly commits to achieving and maintaining a specific inflation rate or range as its primary objective, using interest rate tools and communication to anchor public expectations.
India formally adopted flexible inflation targeting (FIT) as its monetary policy framework in June 2016, following amendments to the RBI Act, 1934. Under FIT, the government and the RBI jointly set a medium-term CPI inflation target of 4 percent, with a tolerance band of +/- 2 percent (2 to 6 percent). The Monetary Policy Committee (MPC) was legally mandated to keep inflation within this band. If CPI inflation stayed outside the band for three consecutive quarters, the MPC was required to report to the government on the reasons for the failure and the remedial measures being taken.
Before FIT, India's monetary policy framework lacked a single nominal anchor. The RBI used to manage multiple objectives simultaneously — inflation, growth, exchange rate stability, and credit conditions — often without explicit priority ordering. This made policy communication ambiguous and inflation expectations less well-anchored. The shift to FIT was influenced by the recommendations of the Urjit Patel Committee Report of 2014, which argued that CPI-based inflation targeting would provide the clearest and most credible framework for reducing India's structurally elevated inflation.
The choice of CPI (Consumer Price Index) over WPI (Wholesale Price Index) as the target variable was deliberate. CPI measured prices of a basket of goods and services consumed by urban and rural households, making it more representative of the true cost of living. WPI, by contrast, was heavily weighted toward commodity and intermediate goods prices, making it a poor proxy for consumer inflation and more volatile in response to global commodity cycles.
Flexible inflation targeting did not mean single-minded focus on inflation to the exclusion of growth. The RBI's mandate under the amended Act was to maintain price stability while keeping in mind the objective of growth. The word "flexible" acknowledged that transient supply-side shocks (food price spikes, fuel price surges) might temporarily push inflation outside the band without warranting an immediate aggressive rate response that could unnecessarily damage growth.
The framework was tested in 2022 when CPI inflation breached 6 percent for three consecutive quarters following the Russia-Ukraine war. The MPC acknowledged the breach, and the RBI Governor communicated the reasons and the remedial actions (the 250-basis-point rate hike cycle between May 2022 and February 2023) in a formal letter to the government. This formal accountability mechanism was a significant institutional innovation compared to pre-FIT India, where policy deviations had no such structured disclosure requirement.
Critics of inflation targeting in India pointed out that a significant portion of CPI inflation was driven by food prices — items outside the direct control of monetary policy. Raising interest rates could not fix a monsoon failure or a global edible oil supply shock. The structural food inflation argument suggested that supply-side interventions in agriculture — storage, logistics, and productivity — were equally important complements to the monetary framework.