Ten years of inflation targeting: RBI’s monetary policy framework has worked could still be improved

Before FIT, India’s monetary policy framework suffered from two drawbacks.

First, even when targets of money supply—an intermediate metric considered the main determinant of inflation over long spans of time—were met, its unstable velocity meant inflation was not always in control.

Second, attaining monetary targets became increasingly difficult as financial innovations, interest rate deregulation and global integration destabilized money demand trends and the money multiplier.

FIT offered a transparent, publicly declared commitment with constrained discretion within the inflation target range. It helped ease RBI’s credibility problem and manage household expectations of inflation. Retail inflation has stayed within the 2-6% tolerance band about 70% of the time since.

Global evidence also suggests that when inflation in several countries surged after the pandemic, reaching 9% in the US and 10% in parts of Europe in 2022, longer-term inflation expectations of households in countries with inflation targeting frameworks, India included, did not move upwards much.

When inflation expectations are stable, the central bank can control inflation at a lower cost—without having to raise interest rates very sharply.

The FIT framework has also brought significant institutional changes: a six-member Monetary Policy Committee (MPC) with equal representation from RBI and government-appointed external members, scheduled meetings, routine publication of MPC minutes, monetary policy reports and improvements in data collection, surveys and research.

How can FIT be improved further?

First, public perceptions of inflation are shaped by a recency bias. Very few can remember what onions or a cab ride cost a year ago. We can recall what we paid more recently.

Year-on-year price changes, which the Consumer Price Index measures, do not reflect this lived reality. Publishing seasonally adjusted month-on-month inflation, as many other central banks do, would close the gap between official data and people’s experience of inflation.

Second, central bank communication is a policy instrument in itself. Policy statements have become more focused with FIT, but ambiguities persist. RBI announces a policy stance, such as ‘neutral’, ‘accommodative’ or ‘withdrawal of accommodation,’ as a separate decision alongside its rate action, making it one of the few central banks to treat its stance label as a distinct policy signal.

It already publishes projections for inflation and growth. This, combined with plain-language guidance stating what would prompt the MPC to act, could communicate better than stance labels.

Third, when RBI’s governor delivers the monetary policy statement, it has no data charts to accompany it. Other central banks have begun to explain their decisions with data visualization. RBI produces plenty of data and does much research. Presenting it visually would make its reasoning behind each policy decision clearer.

Fourth, judging whether inflation expectations are anchored requires separating them into long- and short-run components, and India still lacks robust term-structure information to do so effectively. Encouragingly, RBI has ongoing research in this area.

Fifth, preserving credibility demands rigour. Recent monetary policy statements have referenced trade deals as good news without analysing their impact. It may be better to avoid such statements, particularly given India’s mixed experience with earlier deals.

Sixth, RBI’s communication on its exchange-rate policy has stayed unchanged for years. The standard formulation is that intervention aims to curb ‘excessive and disruptive volatility’ without setting a target level.

However, between 2022 and 2024, the rupee traded in a remarkably narrow band despite significant foreign capital flows. Since late 2024, it has depreciated more freely. If RBI policy hasn’t changed, it would be helpful if the central bank explained what drove such different outcomes under the same framework.

Lastly, monetary policy affects people through prices, borrowing costs and saving returns, but jobs top the minds of people. Yet, employment barely features in RBI communication—possibly because labour-market tightness has not been an inflationary factor in India, data on jobs has been sparse and most of our workers are employed on farms.

Unlike developed economies, India has no estimate of its ‘natural rate of unemployment’ below which inflation may accelerate. As the economy emerges, perhaps non-farm employment data, now available at a higher frequency, would also have to be taken into account by RBI.

Some of these improvements are straightforward to implement. Others require deliberation. But they are worth placing on the table.

The author is Union Bank Chair professor of economics, Great Lakes Institute of Management.