Inflation targeting: What works can still be tweaked to do better

Two, price shocks in sectors such as food have generally not spilled over into the rest of the economy to morph into generalized inflation, a sign that economic agents have growing confidence that the Reserve Bank of India (RBI) will not allow prices to get out of control.

Also Read: Ajit Ranade: RBI must not abandon headline inflation as its target

It is for reasons such as these that most economists have argued over the past week that the current system of monetary management does not need any major change. 

India’s central bank posted a discussion paper on its website on 21 August calling for responses to four questions that need to be examined before the monetary policy framework is reviewed once again in March 2026. Should the preferred inflation target be in terms of headline or core inflation? Is the current inflation target at 4% optimal for a country such as India? Should the tolerance band on both sides of the inflation target be increased, decreased or done away with? Or should a point target be done away with in favour of only an inflation range?

This column focuses on a question that is tangential to the main points raised by the RBI discussion paper. What should be done to strengthen the operation of today’s monetary policy framework, given that it is generally working well? There are three sets of issues that are worthy of attention, and they are sequentially the responsibility of the Indian statistical system, central bank and government.

Also Read: Monetary policy framework review: RBI must keep inflation firmly in its crosshairs

First, monetary policy needs to be supported with better data on whether temporary increases in a few prices could spread to the rest of the economy. There are two major ways this happens. Workers respond to an increase in their cost of living by demanding higher wages. And companies pass on the cost of more expensive inputs to consumers, depending on their pricing power.

India needs a monthly series on wage trends across the economy, rather than the more limited numbers that analysts use on rural wages or salaries paid by listed companies. To pick up latent price pressures on the production side, we need a producer price index (PPI) that captures price changes during the process of production, especially of intermediate goods. This will give  monetary policymakers a useful lead indicator of inflation.

A PPI has a wider coverage than the wholesale price index, so it will also be a better input for India’s GDP deflator. Creating a PPI for services is admittedly a big challenge, but recent innovations and a fresh approach in the Indian statistical system offer hope on this front.

Second, any inflation targeting regime is in effect a system of targeting an inflation forecast, rather than the existing rate, since changes in policy interest rates affect economic activity only with a lag of three or four quarters. Central banks around the world have struggled to correctly forecast turning points in inflation trajectories, which is more of a problem in a volatile world exposed to various exogenous shocks.

A recent paper by economists Alberto Cavallo and Gaston Garcia Zavaleta provides a new way to identify turning points in prices, by measuring inflation as the slope of the log price index, using statistical techniques to identify structural slope breaks, and using highly disaggregated price indices to pick out trend breaks at the micro level. RBI’s inflation forecasting model may also need to add climate variables to its armoury to detect the effects of heat waves or floods on food prices.

Third, the original report that put India on the path to inflation targeting written by a panel headed by Urjit Patel, who was then deputy governor of RBI, had said that the central bank would need support from government fiscal policy. It had called for the government to meet its legal fiscal deficit target of 3% of GDP, as well as do away with administered prices, wages and interest rates.

Also Read: RBI has done well to focus on its core competence: Price stability

The government has shown remarkable fiscal discipline after the pandemic shock, but its deficit is still above the level mentioned in the Fiscal Responsibility and Budget Management (FRBM) Act. The general rule is that monetary policy has to be tighter when fiscal  policy is looser than expected. That changes the trade-off between controlling inflation and stimulating growth for a central bank.

Of the four questions posed by RBI in its discussion paper, the one about whether to maintain or change the numerical inflation target is a tricky one. The original inflation target of 4% was decided when inflation in the advanced economies was anchored at 2%, while another 2% was added to  the Indian target because inflation in developing economies tends to be higher because of the Balassa-Samuelson effect. Inflation in developed  countries is now less stable, so there may be a case for pushing up the Indian inflation target to 5%. 

Yet, it is better for monetary policy credibility to keep the  existing inflation target, since the temptation to tinker with it every five years could rattle inflation expectations over the medium term.

The author is executive director at Artha India Research Advisors.