Flexible Inflation-Targeting Framework

India’s flexible inflation-targeting framework makes price stability the primary objective of monetary policy while requiring the objective of growth to be kept in mind. It targets headline retail inflation measured by the Consumer Price Index, Combined, but provides a tolerance band so that policy need not react mechanically to every temporary shock.

Statutory basis and notified target

Under Section 45ZA of the RBI Act, 1934, the Central Government, in consultation with the RBI, determines the inflation target once every five years. The Monetary Policy Committee, under Section 45ZB, determines the policy rate required to achieve that target.

• The target is based on the year-on-year change in the Consumer Price Index, Combined, published by the National Statistical Office.
• For 1 April 2021 to 31 March 2026, the notified target was 4 per cent, with an upper tolerance level of 6 per cent and a lower tolerance level of 2 per cent.

How the framework constrains monetary policy

The framework gives the MPC a publicly stated benchmark against which its interest-rate decisions and inflation outlook can be assessed. The MPC must therefore justify how its policy-rate decision will return inflation towards 4 per cent, rather than treating the entire 2-6 per cent band as the target.

• If projected inflation is persistently high, the mandate limits the scope for supporting growth through an excessively accommodative policy.
• The focus on headline CPI inflation means that food and fuel price movements cannot simply be excluded from the formal target.
• Policy decisions remain forward-looking because changes in the policy rate affect demand and inflation with a time lag.

Flexibility and accountability

The 2-6 per cent tolerance band allows the MPC to look through temporary supply shocks and balance the speed of disinflation against unnecessary losses of output. This flexibility is bounded by a statutory accountability mechanism.

• Failure occurs when average inflation remains above 6 per cent or below 2 per cent for three consecutive quarters.
• Under Section 45ZN, the RBI must report to the Central Government the reasons for failure, proposed remedial actions and the estimated time for returning inflation to the target.