Flexible Inflation Targeting

Context

India’s Flexible Inflation Targeting (FIT) framework ends in March 2026. The RBI has started a review and asked for views on three issues:

1. Should India target headline inflation or core inflation?
2. What should be the acceptable inflation rate?
3. Should the 2%-6% inflation band change?

What is Inflation?

1. Inflation means a general rise in the overall prices of goods and services in an economy over time.
2. When inflation increases, the value of money falls, meaning you can buy less with the same amount of money.

What is Flexible Inflation Targeting?

1. Flexible Inflation Targeting (FIT) is a system in which the central bank aims to keep inflation within a fixed target range, while also giving itself some flexibility to support growth and handle economic shocks.
2. It was adopted in 2016 after some important reforms like ending automatic monetisation (printing money to finance deficit) in 1994 and introducing fiscal discipline via FRBM (Fiscal Responsibility and Budget Management) Act.
3. Under this, the RBI must keep inflation at 4%, but it can go as low as 2% or as high as 6% (2%-6% range). This gives the RBI flexibility while ensuring price stability.

Why Flexible Inflation Targeting Matters?

FIT is important because:

1. It keeps inflation under control, which helps maintain stable prices in the economy.
2. Stable prices allow people to plan their spending, savings, and investments without fear of sudden price changes.
3. This stability protects poor households the most, because if inflation rises fast, their incomes do not rise at the same pace.
4. It builds confidence among businesses and investors, as predictable inflation makes it easier to make long-term decisions.
5. It supports steady and sustainable economic growth, since very high inflation slows down growth and harms the economy.
6. It prevents misuse of monetary policy, by stopping excessive money printing and making the RBI’s actions more disciplined and transparent.

How Flexible Inflation Targeting Works?

It works through a clear set of steps and principles which ensures that inflation stays controlled while allowing room to handle shocks.

1. RBI studies price trends continuously: It tracks prices of food, fuel, core items, global trends, demand, supply disruptions, and wage pressures to understand where inflation is heading.
2. RBI adjusts interest rates (Repo Rate): If inflation is high, RBI raises interest rates so people borrow less and demand falls, helping cool prices and vice versa.
3. RBI decides what type of inflation to focus on:
   1. Headline Inflation: Includes all items like food, fuel, clothes, housing, transport, etc. Shows the real cost of living for people.
   2. Core Inflation: Removes food and fuel. These are removed because their prices change quickly due to weather or global oil prices.
   3. Headline inflation is better for India because it includes food items whose price changes affect the poor the most, and food inflation in India quickly spreads to the whole economy by raising wages and production costs, eventually pushing up core inflation and giving a complete and realistic picture of overall price changes.
4. RBI decides what inflation level is good for growth:
   1. India’s long-term data shows that growth is highest when inflation is around 4%, and when it goes above 6%, growth falls sharply.
   2. Studies for the next few years also show that keeping inflation below 4% supports better and stable growth, which makes around 4% the most suitable inflation level for India.
5. RBI uses the inflation band (2%-6%) to handle shocks:
   1. To handle unexpected shocks like oil price rise, weather issues, or supply shortages, India uses an inflation band of 2%-6%, which gives the RBI flexibility.
   2. But staying near 6% for too long can reduce growth, and past experience showed that printing money to cover fiscal deficits caused very high inflation.
   3. Therefore, the inflation band must be used carefully, and FIT must work together with the FRBM Act to maintain stability.

Challenges and Way Forward

Conclusion

Keeping inflation near 4%, focusing on headline inflation, and maintaining strong fiscal-monetary coordination will support India’s economic stability in the coming years.