The RBI’s Flexible Inflation Targeting (FIT) framework will turn 10 next year, and the central bank believes it has met its expectations. Over the last nine years, India experienced a hump-shaped performance, with inflation behaving like an obedient child in the first and last three years. The middle three years saw retail prices breach the upper tolerance band, mainly due to the Covid-19 pandemic and the Russia-Ukraine war. If average inflation hovered around 4 percent from 2016 to 2019, it stayed above 6 percent for five quarters from the first quarter of Financial Year 2022 to the fourth quarter of Financial Year 2023. With a review slated next March, key questions arise: Should core inflation replace headline inflation as the anchor for monetary policymaking, as suggested by the Economic Survey, 2025? Or should the government re-examine the 4 percent target and consider establishing a tolerance band?
Those championing core inflation argue that the food component is outside the RBI’s purview and, therefore, core inflation should guide policy. They reason that stabilising core inflation leads to better economic outcomes. However, RBI maintains that persistent food inflation can spill over to core inflation through higher wage costs, higher rents, and higher markups. Which is why its expert committee in 2014 insisted that since food and fuel constitute more than 50 percent of the consumption basket, inflation based on less than half the basket would not be representative. As former Governor Shaktikanta Das noted, eliminating food from the target would amount to having no target at all. “It will make no sense to the average citizen, as it is the headline inflation that the common person understands and should remain that way.” Even as the debate over core vs headline remains unfinished, there’s another view that the inflation target itself needs to be reset.
However, the central bank may not be in agreement. In its recent discussion paper, it noted that changing the target now, when the global economy is confronted with geopolitical uncertainty, can be interpreted by international investors as a dilution of the IT framework, thereby undermining policy credibility. It reasoned that the current tolerance band of 2-6 percent allows headroom to account for deviations from temporary food and fuel price shocks. That said, price stability is a shared responsibility between the government and RBI, and hence needs effective monetary-fiscal coordination to prevent second-round inflationary effects.