Flexible Inflation Targeting (FIT) Framework in India

The current Flexible Inflation Targeting (FIT) framework in India mandates that monetary policy aims to manage inflation at 4% with a tolerance band of +/- 2%. This framework is set to end in March 2026 and is currently under review by the Reserve Bank of India (RBI).

Discussion Points and Key Questions

The RBI's recent discussion paper raises several pivotal questions, including:

• Should the focus be on headline or core inflation?
• What is the acceptable level of inflation?
• What should be the inflation band?

It's crucial to understand that controlling inflation is a vital goal of monetary policy as high inflation acts as a regressive consumption tax, disproportionately affecting poorer households and distorting savings and investments.

Historical Context and Evolution of Policy

The acceptable level of inflation was first discussed by the Chakravarty Committee, which suggested an acceptable rise in prices of 4%. India has been working on inflation management since the dismantling of automatic monetisation in 1994, which granted the RBI functional autonomy for monetary policy. In 2016, India adopted the FIT framework, providing institutional autonomy, which has helped maintain inflation within a range, despite several shocks.

Headline vs Core Inflation

One ongoing debate is the focus on headline versus core inflation. Headline inflation, which includes food prices, should be targeted if the aim is to protect savings, investments, and the poor. The assumption that food inflation is solely due to supply shocks is contested. It's noted that food inflation can be higher in an expansionary monetary policy environment than in a contractionary one.

Milton Friedman's insights highlight that without an overall increase in money supply, general price levels cannot rise. The debate often overlooks the distinction between changes in relative prices and the general price level. Indian data show that food inflation can influence core inflation through upward wage pressure, which affects the general price level if aggregate demand grows.

Inflation and Growth

Studies based on the Phillips Curve suggested a trade-off between growth and inflation, but empirically, this notion has not held up over time. There is only a short-run trade-off, and in the long run, expectations nullify it. However, even in the short run, low inflation can aid growth, but high inflation is detrimental, leading to the concept of threshold inflation.

Historical data indicate a non-linear relationship, with a point of inflection at 3.98%, suggesting an acceptable inflation rate of about 4% for India. Simulations suggest maintaining inflation below 4% is ideal, considering growth and macroeconomic conditions.

Inflation Band and Fiscal Policy

The current band of +/- 2% offers flexibility for monetary authorities, but a prolonged stay at the upper limit undermines the framework's intent. Inflation above 6% results in a significant growth decline. Fiscal policy navigation is crucial, as past high inflation was caused by the monetisation of fiscal deficits, leading to reforms like abolishing ad hoc treasury bills and the Fiscal Responsibility and Budget Management (FRBM) Act. FIT and FRBM provisions must align to ensure macroeconomic stability.