Flexible inflation targeting

Also called: FIT · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Beyond NCERT

Meaning

Flexible inflation targeting (FIT) is India's monetary policy framework. Under it, the RBI's main job is to keep CPI-Combined inflation at a target set by the Central Government, while also keeping growth in mind. The target is 4%, with a band of 2-6%. It is fixed once every five years under s.45ZA of the RBI Act, 1934 [3], and has been kept for 1 Apr 2026 – 31 Mar 2031 [2].

FIT matters because it gives the RBI one clear, public goal and makes the RBI answer for missing it. The band also leaves room so that fighting inflation does not crush growth.

Explanation

From earlier frameworks to inflation targeting

A monetary policy framework is the set of rules that tells the central bank which goal to chase and which tool to use.

• Credit planning (1950s-80s): the RBI decided how much credit (loans) each sector would get. It used direct controls such as CRR, SLR and selective credit controls, not interest rates.
• Monetary targeting with feedback (from 1985): this came from the Chakravarty Committee (1985).
• The RBI set a target for growth of M3 (broad money: currency with the public + all bank deposits + other deposits with RBI).

• It stopped working well when financial reforms made the link between money and prices unstable.

• Multiple-indicator approach (1998): the RBI watched many signals together, such as interest rates, credit, the exchange rate, trade, fiscal data and output.

• Weakness: there was no single clear anchor, so the public could not easily judge the RBI.

• Inflation targeting (IT): the central bank publicly commits to a number for inflation and uses the policy rate as its main tool. New Zealand was the first country to adopt it, in 1990.

• Steps to IT in India: 1. Urjit Patel Committee (Jan 2014): recommended CPI as the anchor and a 4% target with a band. 2. Monetary Policy Framework Agreement (Feb 2015): under this agreement between GoI and the RBI, price stability became the RBI's main job. 3. Finance Act 2016: amended the RBI Act, 1934 and added Chapter IIIF (ss.45Z-45ZO). This gave the framework a legal (statutory) basis.

What makes it "flexible"

• Strict inflation targeting: the central bank looks only at inflation.
• Flexible inflation targeting: the RBI also weighs growth and output volatility (big swings in output and jobs).
• The band gives room.
• Example: a food-price shock pushes inflation to 5.5%. This is inside 2-6%, so it is not a failure.

• The RBI can bring inflation back to 4% along a glide path (a slow, step-by-step route). It does not have to cut growth sharply.

• How a rate rise cools inflation:

• repo rate (the rate at which the RBI lends money to banks for a short time against government securities) goes up → bank loans cost more
• → people and firms borrow and spend less
• → demand cools → prices rise more slowly

"Failure" and accountability

• Failure means average CPI inflation stays above 6% or below 2% for three consecutive quarters.
• Worked example (Nov 2022): inflation stayed above 6% in all three of these quarters:
• Jan-Mar 2022
• Apr-Jun 2022
• Jul-Sep 2022

• That made three quarters in a row, so failure was invoked for the first time.

• What the RBI must then do: send a written report to GoI that explains:

• why the target was missed;
• what remedial steps it proposes;

• how long it expects to take to bring inflation back to target.

• Why this matters: the RBI must explain itself in writing to the elected government. This builds credibility.

Tools that guide the rate decision

• Taylor rule: a rule of thumb for where the policy rate should be.

i = r* + π + 0.5(π − π*) + 0.5 × output gap

• i = nominal policy rate; r* = neutral real rate; π = current inflation; π* = inflation target.
• Output gap = (actual GDP − potential GDP) ÷ potential GDP. It is positive when the economy is running "too hot".

• Worked example (illustrative numbers): r* = 1.5%, π = 6%, π* = 4%, output gap = −1%

  • i = 1.5 + 6 + 0.5(6 − 4) + 0.5(−1)
  • = 1.5 + 6 + 1 − 0.5 = 8.0%
  • Inflation is above target, so the rule says to raise the rate. The negative output gap makes that rise a little smaller. This shows the "flexible" side of FIT.

• Neutral rate of interest (r*): the real rate at which output stays at potential and inflation stays stable. It neither pushes the economy up nor holds it back.

• The RBI estimates it at about 1.4-1.9% (verify current).
• Real rate ≈ nominal rate − expected inflation.
• Example: repo 5.25% − expected inflation 4% = a real rate of about 1.25%. This is just below 1.4-1.9%, so policy would be mildly stimulative, meaning it gently supports growth (illustrative numbers).

In India

• Who sets the target: the Central Government, in consultation with the RBI, once every five years, under s.45ZA of the RBI Act, 1934 [3].
• Target: CPI-Combined (the Consumer Price Index for rural + urban India, published by NSO under MoSPI) inflation of 4% ±2%. This is headline inflation, which covers all items, including food and fuel.
• Timeline of the target:

Period	What happened
5 Aug 2016 – 31 Mar 2021	First target: 4% (2-6%), notified by GoI in consultation with the RBI [1]
Mar 2021	First review: target kept for five more years, till Mar 2026 [3]
21 Aug 2025	RBI releases a Discussion Paper on Review of Monetary Policy Framework. It asked three questions: headline or core, is 4% right, and is ±2% the right width? Comments were open till 18 Sept 2025 [3][4]
25 Mar 2026	Second review: GoI keeps 4% ±2% on headline CPI for 1 Apr 2026 – 31 Mar 2031 [2]

• Who runs it: the Monetary Policy Committee (MPC), under s.45ZB, set up in Sept 2016.
• It has 6 members:
  • the RBI Governor (Chair, with a casting vote when votes are tied 3-3);
  • the Deputy Governor in charge of monetary policy;
  • one RBI officer nominated by the RBI's Central Board;
  • three external experts, appointed by GoI on a search-cum-selection committee's advice, for 4 years and not eligible for reappointment.
• Quorum (the minimum number of members needed for a valid meeting): four.

• The law requires at least four meetings a year. In practice there are six (bimonthly).

• Transparency:

• A resolution after each meeting gives the decision and the vote.
• Minutes come out on the 14th day and show each member's vote and statement. Example: decision on 5 Aug 2026, minutes on 19 Aug 2026 [5][6].

• A Monetary Policy Report every six months explains where inflation comes from and gives forecasts.

• Latest decision (MPC meeting, 3-5 Aug 2026):

• repo rate 5.25%
• SDF 5.00% (Standing Deposit Facility: the rate at which banks park extra money with the RBI; repo − 0.25%)
• MSF and Bank Rate 5.50% (Marginal Standing Facility: the rate at which banks borrow in an emergency; repo + 0.25%)
• The decision was unanimous, and the stance stayed neutral [5].

Don't confuse with

• Strict inflation targeting: looks at inflation alone. FIT also weighs growth and output swings, and uses a ±2% band and a glide path.
• Monetary targeting (Chakravarty Committee, 1985): targeted M3 money growth, not inflation. FIT targets CPI inflation directly and uses the repo rate as its tool.
• Core inflation / WPI: core inflation leaves out food and fuel, and WPI is a wholesale price index. India's target is headline CPI-Combined, and the 2026 review kept it that way [2].
• Goal independence vs instrument independence: under FIT, GoI sets the goal (the target). The RBI only chooses the tool setting, for example the repo rate level. So India has instrument independence, not goal independence.

Prelims Hooks

• The inflation target is set by the Central Government in consultation with the RBI, every 5 years, under s.45ZA of the RBI Act. The RBI does not set it alone [3].
• Target = CPI-Combined (headline) 4% ±2%. It is not WPI and not core CPI. It has been retained for 1 Apr 2026 – 31 Mar 2031 [2].
• Failure = inflation outside 2-6% for three consecutive quarters. It was first invoked in Nov 2022.
• The legal basis is Chapter IIIF (ss.45Z-45ZO) of the RBI Act, added by the Finance Act 2016. The MPC comes under s.45ZB.
• Trap: the MPC decides only the repo rate and the stance. CRR and SLR stay with the RBI.
• New Zealand (1990) was the first country to adopt IT. In India, the Urjit Patel Committee (2014) recommended it.

Mains Points

• Credibility vs flexibility: a fixed 4% anchor has lowered and steadied inflation expectations (what people think prices will do) since 2016. The ±2% band and the glide path let the RBI absorb food and fuel shocks without hurting growth too much. Renewing every feature in 2026 shows the framework is now firmly settled [2].
• Headline vs core debate: food is a large share of CPI, and interest rates cannot fix a vegetable-price shock. That is the case for targeting core inflation. The other side says food prices shape what households expect, so the RBI must respond to them. The Aug 2025 paper raised this question, but GoI kept headline CPI [3][2].
• Accountability, independence and fiscal pressure (GS-II/GS-III):
• The MPC vote, published minutes and the written failure report make the RBI answerable.
• But GoI sets the goal, appoints half the MPC and holds s.7 powers to give the RBI directions.
• Automatic monetisation (the RBI printing money to cover the government's shortfall) ended in 1997. Since 2006, FRBM has barred the RBI from buying new government bonds when they are first sold.
• Even so, large deficits still create pressure for low rates. When the government borrows less, the MPC finds it easier to hit the target, and rate cuts reach borrowers faster.

Related concepts

• Inflation targeting
• Monetary Policy Committee
• Monetary policy stance
• Central bank independence
• Fiscal dominance
• Taylor rule
• Neutral rate of interest

Read more

• MPC and flexible inflation targeting