Does inflation targeting work in India?

Why in news? 

India has just completed a decade of inflation targeting (IT) as a formal policy framework of the Reserve Bank of India.

UPSC Relevance 

Prelims

GS-III: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Present Inflation Targeting Practices in India

• Flexible Inflation Targeting (FIT): India adopted FIT following the Urjit Patel Committee recommendations (formalized via an RBI Act amendment in 2016). The target is set at 4% headline CPI inflation with a tolerance band of +/- 2% (2 % to 6 %).
• Trap: Doesn’t target core CPI Inflation. Only headline CPI is targeted under FIT. 

Statutory Provisions under the RBI Act, 1934

• Determination of Target : Mandates that the Central Government, in consultation with the RBI, determine the inflation target in terms of CPI once every five years.
• ​Institutional Decision-Making: Rate decisions are made by a 6-member Monetary Policy Committee (MPC) rather than solely by the RBI Governor.
• Constitution of MPC : Establishes the 6-member Monetary Policy Committee comprising:
  • ​The RBI Governor (Ex-officio Chairperson)
  • ​Deputy Governor in charge of monetary policy
  • ​One RBI officer nominated by the Central Board
  • ​Three external members appointed by the Central Government
• Failure Clause: Defines failure to meet the target as average CPI inflation remaining above 6% or below 2% for three consecutive quarters.
• ​Accountability Mechanism : In the event of failure, the RBI must submit a report to the Central Government explaining:
  • ​The reasons for failing to achieve the target.
  • ​Remedial actions proposed by the RBI.
  • ​An estimated time period within which the target will be achieved.

• Transmission Channels of FIT: Both these routes work through a relationship called the New Keynesian Phillips curve (NKPC).
  • Demand Management Channel: Increasing the Repo rate makes borrowing expensive for consumers and businesses, deferring consumption and investment, thereby suppressing aggregate demand to curb inflation.
  • Expectations Anchoring Channel : If the public believes the central bank will keep inflation low, workers ask for lower wage hikes, and businesses set smaller price increases, preventing a wage-price spiral.
• ​The Inverse Relationship: As economic activity expands, employment rises and unemployment drops. Higher demand for workers gives labor greater bargaining power, driving up money wages and prices (higher inflation). Conversely, high unemployment depresses wages and lowers inflation.
• ​Thus, a Policy Trade-off: Policymakers face a dilemma—reducing inflation typically requires sacrificing short-term growth and accepting higher unemployment, whereas stimulating employment runs the risk of increasing inflation.

Key Economic Concepts 

• Inflation is defined as a sustained, broad-based increase in the general price level of goods and services in an economy over a specific period of time.
• The Phillips Curve is an economic concept that describes the inverse relationship between inflation and unemployment in an economy as highlighted in the previous section.
• Flat Phillips Curve:
  • Represents a scenario where output changes do not affect inflation rate movements significantly.
  • Cause in India: Over 92% of India’s workforce operates in the informal sector with minimal to no collective bargaining power. They act as “price takers,” so higher employment does not automatically lead to higher nominal wage pressures or demand-driven inflation.
    • This different scenario in India causes the failure of conventional monetary policy.

Does Inflation Targeting Work in India? 

• Failure of the Demand Route: Since the empirical Phillips Curve for India is virtually flat, altering interest rates reduces GDP growth and employment without meaningfully reducing inflation.
• Failure of the Expectations Route: RBI’s Household Inflation Expectation Surveys reveal that household expectations remain consistently higher than actual inflation and RBI’s projections (by around 4 percentage points), failing to anchor expectations.
• Risk of Policy-Induced Stagflation: Raising interest rates when the NKPC is flat compresses economic output without bringing down inflation, creating artificially suppressed growth and job losses.
• Structural vs. Monetary Inflation: Inflation in India is heavily driven by supply-side shocks (food prices, fuel costs, climate disruptions) rather than demand-pull dynamics. Monetary policy toolkits are ill-suited to fix supply bottlenecks.

Way Forward

• Need for Flexible Policy Frameworks: Re-evaluate the rigid reliance on repo rate hikes when dealing with supply-side or cost-push inflation.
• Supply-Side Interventions: Utilize fiscal policy instruments, such as stock management, buffer stocks (e.g., buffer maintenance for pulses/grains), trade policy adjustments, and logistics infrastructure, rather than relying solely on monetary contraction.
• Formalization and Labor Reform: Addressing low worker bargaining power through structural labor welfare, formalization, and minimum wage enforcement is critical to aligning theoretical economic assumptions with ground realities.

Mains Practice Question:

Critically examine the efficacy of Flexible Inflation Targeting (FIT) in India, given the structural constraints Indian Economy. (10 Marks, 150 Words)

UPSC Prelims Practice MCQ :

Q. With reference to Flexible Inflation Targeting (FIT) in India, consider the following statements:

​1. Under the RBI Act, 1934, the Central Government, in consultation with the RBI, sets the CPI inflation target every five years.

2. ​Monetary Policy Committee (MPC) failure occurs if headline CPI remains above 6% or below 2% for two consecutive quarters.

​3. Core CPI inflation serves as the statutory operational target under FIT.

​Which statements above are correct?

​(a) 1 only

(b) 1 and 2 only

(c) 2 and 3 only

(d) 1, 2, and 3

​Answer: (a) 1 only

​Explanation:

​Statement 1 is correct: Mandated under Section 45ZA of the RBI Act, 1934.

​Statement 2 is incorrect: Failure is defined as missing the tolerance band (2\% \text{ to } 6\%) for three consecutive quarters, not two.

​Statement 3 is incorrect: Headline CPI-Combined (not Core CPI) is the official statutory target.