Flexible Inflation Targeting in India: Risks and Challenges
In February 2015, the Reserve Bank of India (RBI) and the finance ministry agreed on a monetary policy framework to focus on flexible inflation targeting (FIT). As per the agreement, (a) the RBI will aim to bring down inflation below 6% by January 2016, (b) bring down inflation to 4% (with a band of + 2%) in the 2016-17 and subsequently, (c) in case the RBI fails in meeting the target, it will have to report to the government the reasons for its failure and remedial measures.

The recommendations for moving towards a flexible inflation targeting regime were made in the Urjit Patel Committee Report (UPCR) in January, 2014.  As per the UPCR, the flexible inflation targeting aims at anchoring inflation expectations, improves overall macroeconomic stability and enhances growth prospects in the medium run. At the same time, this regime allows the inflation to deviate from the target in the short run to accommodate growth. Strict inflation targeting on the other hand aims at stabilizing the inflation only, disregarding the impact on the real economy Gupta and Sengupta (2014). UPCR�s recommendation to move towards this system has also brought about much debate on the benefits and costs on the same.

As per the Percy Ministry Report (2007), an institutional obligation to predictable and low inflation would mitigate risks of capital flights as value of the rupee would be maintained in the real terms and expectations about its future values remain stable. Some in favor of the FIT system also opine that it would make monetary policy more transparent and predictable and the agreement will strengthen coordination between the government and RBI. However, Subbarao (2009) and Gupta and Sengupta (2014) have pointed several challenges to the implementation of the FIT system. Some of the challenges that have been highlighted in these studies are:

(a) Food items have about 39 % weight in the CPI basket. Absence of supply side measures make the food supply vulnerable to shocks which are beyond the vagaries of monetary policy. (b) Inefficient transmission mechanism due large fiscal deficit; presence of administered prices and illiquid bond market.

Table: Weights of different categories of CPI


Group description

CPI- New series

Food and beverages


Pan, tobacco and  intoxicants


Clothing and Footwear




Fuel and Light







Source: CSO

The adoption of the FIT regime has also brought to fore a major concern of RBI becoming what former Governor of Bank of England, Mervyn King (1997) has described as being  �INFLATION NUTTERS�.  and thus putting growth on the back-burner. Gupta and Sengupta (2014) in their study (using Taylor rule

[1])  have shown that in the past the  RBI has not been consistently responsive to output growth putting greater emphasis to inflation rate compared to output gap. This might mean that the Central Bank in its overwhelming desire to manage inflation could put growth on the back burner. The study also points to the challenges in the management of the impossible trinity- which points out that it is impossible to attain monetary policy independence, exchange rate stability and capital market regulation simultaneously all at once and only two of these three can be achieved at a particular point in time. The adoption of FIT mechanism might result in the central bank renouncing exchange rate management in favor of greater monetary dependence.Thus, while the FIT regime is expected to bring about transparency, certainty and accountability in the inflation management process, supply bottlenecks in the agriculture sector and long and uncertain time lags in the monetary policy transmission could impose a challenge. The RBI also needs to consciously exercise caution on the adverse impact of the FIT regime on other macro- financial variables like output, fiscal policy, exchange rate management and financial stability.

—Purva Singh


Notes: 1. Taylor rule estimates the desired level of interest rates based on two parameters: first, the output gap, or the difference between actual output and potential output, and second, the inflation gap, or the difference between actual and targeted rate of inflation.


Gupta, A. S. and Sengupta, R. 2014, Is India Ready for Flexible Inflation-Targeting?

HPEC (2007) Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre, Ministry of Finance, Government of India

Subbarao, D. (2009), Global Financial Crisis- Questioning the questions, JRD Tata Memorial Lecture, New Delhi, 2009