10 Years of Flexible Inflation Targeting in India: Successes, Limitations, and the Road Ahead

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Key takeaways

India completed 10 years under the Flexible Inflation Targeting (FIT) regime, which helped lower average retail inflation from 6.8% to 4.9%.
Empirical evidence reveals a flat New Keynesian Phillips Curve (NKPC) in India, indicating that policy rate hikes reduce economic output without proportional falls in inflation.
Nearly 92% of Indian workers operate in the informal sector without wage-bargaining power, breaking the theoretical link between growth and wage-driven inflation.
Household inflation expectations remain unanchored, consistently exceeding official Reserve Bank of India (RBI) projections by about 4 percentage points.
Strengthening price stability requires combining monetary policy with coordinated supply-side measures, food buffer releases, and an updated Consumer Price Index (CPI) basket.

India has completed 10 years of implementing the Flexible Inflation Targeting (FIT) monetary framework.
This completion has prompted significant debate among economists about whether rate hikes effectively control inflation without harming economic growth.
A major study published in the Economic and Political Weekly (EPW) highlights critical gaps between theoretical monetary models and actual Indian market conditions.

Flexible Inflation Targeting (FIT) is a monetary policy system where the central bank uses policy interest rates to maintain inflation within a specified, publicly announced range while supporting economic growth.
India formally adopted the FIT framework in 2016 based on the recommendations of the Urjit Patel Committee.
Section 45-ZA of the amended Reserve Bank of India Act, 1934 legally mandates the central government to determine the official inflation target every 5 years in consultation with the RBI.
The government retained the 4% retail inflation target with an allowable tolerance band of 2% to 6% for the period from 1st April, 2026 to 31st March, 2031.
The central bank uses the Headline Consumer Price Index (CPI-Combined) with 2024 as the base year as the primary anchor to track price changes.
If average inflation stays outside the 2% to 6% band for 3 consecutive quarters, the RBI fails its official mandate and must submit a detailed explanation report to the government.

The central bank influences inflation primarily through two operational channels: aggregate demand and public expectations.
Under the aggregate demand channel, the RBI raises the repo rate when price pressures rise.
Higher policy rates increase commercial lending costs, making consumer credit and business investments more expensive.
Higher borrowing costs lead households and firms to delay expenditure, reducing overall market demand and cooling price increases.
Under the expectations channel, setting an explicit numerical target anchors future price expectations among the public.
When citizens expect general price stability, workers do not demand aggressive wage increases and firms refrain from preemptive price hikes.

The New Keynesian Phillips Curve (NKPC) outlines the theoretical relationship between national economic output and inflation rates.
The model assumes that rising economic output expands employment and gives workers stronger bargaining power to demand higher wages.
Firms then increase product prices to cover these higher wage costs, generating an upward-sloping inflation curve.
Under standard NKPC theory, monetary authorities suppress inflation by reducing output or lowering public expectations.

Empirical economic data from April 2012 to March 2026 indicates that India has a nearly flat Phillips Curve.
A flat curve means that raising interest rates reduces national output and employment significantly without yielding a proportional reduction in inflation, raising risks of stagflation.
The framework relies on wage-push assumptions that fail in India, where nearly 92% of the workforce works in the informal sector without wage-bargaining power.
Because informal workers are price takers rather than price setters, economic expansion does not trigger wage-driven inflation.
Public inflation expectations remain unanchored, with household expectations consistently exceeding central bank projections by about 4 percentage points.
Indian inflation is largely driven by supply-side shocks such as volatile food prices, monsoon failures, and global energy price fluctuations.
Because monetary policy is purely a demand-management tool, interest rate hikes cannot resolve agricultural supply shortages or fuel supply shocks.
High interest rates place an unequal burden on the real economy, squeezing MSMEs and prospective homebuyers while dampening job growth in construction and manufacturing.
The central bank also faces liquidity management friction when managing foreign exchange reserves creates surplus market liquidity that undermines high interest rate stances.

The FIT framework has maintained overall macroeconomic stability, reducing average inflation from 6.8% in the pre-FIT era to 4.9% between 2016 and 2025.
Inflation performance followed an inverted-U trajectory, remaining close to the 4% target in initial and recent periods while peaking near 6% during the COVID-19 pandemic and European conflicts.
Central bank research covering 1991 to 2023 shows that India achieves maximum economic growth when retail inflation remains near the 4% baseline target.
Statutory backing for the Monetary Policy Committee (MPC) has enhanced institutional independence and insulated monetary decisions from fiscal pressures.
Rate hikes prevent temporary food and energy price shocks from embedding into general core inflation and wider public inflation expectations.
A transparent rate framework preserves real interest rate differentials against global central banks, protecting the value of the Indian Rupee and preventing capital flight.
The flexibility built into the 2% to 6% tolerance band allows policymakers to absorb severe external shocks without abandoning medium-term price stability.

The government and central bank should establish a joint food inflation response mechanism that automatically triggers buffer stock releases and import duty adjustments when food inflation hits 6% over three months.
Policymakers should evaluate whether targeting Core Inflation provides a more stable anchor than headline CPI, which is heavily skewed by volatile food items.
Monetary transmission should be extended to the informal economy by introducing transparent benchmark pricing for NBFCs and MFIs alongside credit guarantees for small businesses.
The government should reintroduce liquid, retail-oriented Inflation-Indexed Bonds to provide households with a reliable inflation hedge beyond physical assets like gold.
The MPC should establish clear quantitative triggers for second-round inflation effects before raising interest rates, minimizing unnecessary growth costs.
Statistical authorities should update the CPI consumption basket weightings, which currently rely on an outdated 2011-12 base, to reflect modern household spending patterns where food carries a smaller weight.
Long-term structural investments in climate-resilient cold chains, modern storage facilities, and agricultural processing are essential to prevent recurring supply shocks.