Flexible Inflation Targeting

Flexible Inflation Targeting (FIT)

Syllabus Areas:

GS III - Economy

India’s existing Flexible Inflation Targeting (FIT) framework—mandating inflation at 4% ± 2%—expires in March 2026. The RBI has released a detailed discussion paper to reassess the next phase of monetary policy design.
Three major questions under review are:

1. Whether inflation targeting should focus on headline or core inflation
2. What should be the acceptable or optimal inflation rate for India
3. Whether the tolerance band should be modified

This review is crucial because the target set now will influence India’s macroeconomic stability for the next half-decade.

Why Inflation Control Matters

Inflation policy is not merely a technical statistic—it's a distributive issue.

• High inflation behaves like a regressive tax^[1], hitting poorer households harder.
• Persistent inflation discourages savings, misdirects investments, and increases macroeconomic uncertainty.
• Even historically, the Chakravarty Committee (1985) suggested 4% as a tolerable inflation rate—though their reasoning was fuzzy, it aligned with India’s structural realities.
• Post-1994, the RBI gained autonomy after the abolition of automatic monetisation, strengthening its commitment to price stability.
• Since the adoption of FIT in 2016, inflation has remained comparatively range-bound despite shocks like COVID-19, wars, supply disruptions, and climatic volatility.

Inflation control has thus become central to sustaining growth, investment confidence, and macroeconomic credibility.

Headline vs Core Inflation: What Should India Target?

Headline Inflation:

• Headline inflation measures the overall change in the price level of a basket of goods and services, including food and fuel. It reflects the actual cost-of-living pressures faced by households and is directly influenced by supply shocks and demand conditions.

Core Inflation:

• Core inflation excludes volatile items like food and fuel to capture underlying, persistent price trends. It helps assess demand-driven inflation and long-term monetary pressures, providing a cleaner signal for policy decisions but missing immediate cost-of-living effects.

^[1] Regressive Tax: A regressive tax is a tax structure in which lower-income individuals pay a larger percentage of their income compared to higher-income groups. Even if the tax amount is the same for everyone, it absorbs a bigger share of poor households’ earnings, making the burden heavier and deepening economic inequality.

Why Headline Inflation Matters

The RBI and many economists revisit this debate often. But India’s consumption and income profile demands a hard-nosed clarity:

• Headline inflation directly represents the cost of living, affecting poor households the most.
• The assumption that “food inflation is only supply-driven” is not always correct. Under expansionary money supply, food prices can rise disproportionately.

The Friedman View — Still Relevant

Milton Friedman’s Mumbai lecture (1963) remains a reminder:

The general price level cannot rise without an expansion in overall liquidity.

This means:

• Relative price shocks ≠ inflation
• Money supply expansion + sustained food inflation = generalised inflation

Second-Round Effects

Indian data shows:

• Food inflation → wage pressures → core inflation
• In such a scenario, targeting only “core” misses the base of the problem.

Verdict

A realistic, poverty-sensitive, forward-looking policy must target headline inflation, not merely the sanitized “core”.

Acceptable Inflation Level: Should It Remain at 4%?

The Growth–Inflation Relationship

Old Phillips Curve arguments suggesting a trade-off don’t hold in the long run.
However:

• At very low inflation, growth is supported.
• But beyond a threshold, inflation becomes a growth killer.

Empirical Insights

A quadratic analysis of inflation and growth since 1991 (excluding COVID-19) shows:

• Inflection point near 98%
• Suggests optimal inflation ≈ 4%
  
  

Forward-Looking Assessment (2026–2031)

Preliminary simulations show:

• Acceptable inflation below 4% may be ideal
• But uncertainty remains around fiscal policy, global commodity risks, climate shocks, and external balance pressures

Conclusion on Target

There is no convincing macroeconomic case for raising the inflation target above 4%.
If anything, future conditions argue for staying at or slightly below 4%.

The Inflation Band: Should the ±2% Range Change?

What Has Worked

The current 4% ± 2% band has:

• Given RBI enough flexibility
• Allowed it to navigate massive supply shocks
• Preserved policy credibility

The Real Missing Element

What is not specified is how long inflation can hover near the upper band.

Why this matters:

• Persistent inflation near 6% kills the purpose of FIT
• Historical data shows growth declines sharply beyond 6%
  
  

Policy Dependencies

FIT cannot function in isolation.

• 1970s–80s high inflation was driven by fiscal deficit monetisation
• This led to reforms:
  • Abolishing ad hoc treasury bills
  • Fiscal Responsibility and Budget Management (FRBM) Act
• FIT is the natural successor to FRBM in India’s macro framework

If FRBM slips, FIT becomes ineffective — and vice-versa.

Band Verdict

• The ±2% band is adequate. The real reform needed is defining persistence limits near the band edges and improving fiscal-monetary coordination.

Way Forward:

1. Continue targeting headline inflation, not core
2. Retain 4% as the central target, with evidence supporting this threshold
3. Keep the ±2% band, but set clearer rules for prolonged breaches
4. Strengthen coordination with FRBM and fiscal consolidation
5. Improve data-driven, forward-looking estimations for food inflation, climate impacts, and commodity cycles

The upcoming review of FIT is not a mere technocratic exercise—it will shape India’s economic stability till 2031. A cautious yet firm approach suggests retaining the current framework but strengthening its operational clarity. The goal is simple: protect the poor, preserve growth, and maintain macroeconomic discipline.

Prelims Questions: