Inflation targeting

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

Meaning

Inflation targeting (IT) is a monetary policy framework (the set of rules that tells a central bank what goal to chase and which tool to use). Under it, the central bank publicly commits to a numerical inflation target and uses its policy rate as its main tool to reach that target.

It matters because a clear, public number gives the economy one fixed anchor. People and firms can check whether the central bank is doing its job. That builds credibility and keeps inflation expectations (what people think prices will do next) steady. New Zealand was the first country to adopt it, in 1990.

Explanation

How it works

• Step 1: fix the target. A number is announced, for example 4% inflation with a band around it.
• Step 2: watch inflation against the target. The central bank compares actual and forecast inflation with the target.
• Step 3: move the policy rate. In India this rate is the repo rate (the interest rate at which RBI lends money to banks for a short time against government securities).
• When inflation is above target, the chain works like this:
• repo rate goes up → bank loans cost more
• → people and firms borrow and spend less

• → demand cools → prices rise more slowly

• When inflation is below target, the chain runs the other way. A rate cut makes loans cheaper and lifts demand.

• Step 4: communicate. Published decisions, votes and forecasts shape inflation expectations. Expectations then affect wages and prices.

Strict vs flexible inflation targeting

• Strict IT: the central bank looks only at inflation.
• Flexible inflation targeting (FIT): the central bank also weighs growth and output volatility (big swings in output and jobs). India follows FIT.
• The band gives room. A food-price shock can push inflation to, say, 5.5% without counting as a failure.
• The glide path. RBI brings inflation back to 4% by a gradual route instead of cutting growth sharply.

How India moved to IT

• Credit planning (1950s-80s): RBI decided how much credit went to each sector. It used direct controls such as CRR and SLR, not interest rates.
• Monetary targeting with feedback (from 1985): this came from the Chakravarty Committee (1985).
• RBI targeted M3 growth. M3 is broad money: currency with the public + all bank deposits + other deposits with RBI.

• It weakened when financial reforms made the link between money and prices unstable.

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

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

• Inflation targeting: it came in three steps. 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): a GoI-RBI agreement that made price stability RBI's main job. 3. Finance Act 2016: amended the RBI Act, 1934 and added Chapter IIIF (ss.45Z-45ZO). This gave IT a legal (statutory) basis.

Worked example: the Taylor rule

The Taylor rule is a rule of thumb for where the policy rate should be under inflation targeting.

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 runs "too hot".
• 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%

• Reading it: inflation is above target, so the rule says raise the rate. The negative output gap softens that rise a little.

In India

• Who sets the target: the Central Government, in consultation with RBI, once every five years, under s.45ZA of the RBI Act, 1934 [3]. RBI does not set it alone.
• The target: CPI-Combined inflation of 4%, with a band of 2-6% (±2%).
• CPI-Combined is the Consumer Price Index for rural + urban India. NSO (MoSPI) publishes it.

• It measures headline inflation (all items, including food and fuel).

• Timeline:

• First target: 4% (2-6%), valid from 5 Aug 2016 to 31 Mar 2021 [1].
• First review (Mar 2021): target kept till Mar 2026 [3].
• 21 Aug 2025: RBI released a Discussion Paper on Review of Monetary Policy Framework [3][4]. It asked three questions: headline or core inflation, whether 4% is still right, and whether the 2-6% band is the right width. Public comments were open till 18 Sept 2025 [3][4].

• Second review (25 Mar 2026): GoI kept 4% ±2% on headline CPI for 1 Apr 2026 – 31 Mar 2031, with all features unchanged [2].

• Failure clause: RBI has failed if average CPI inflation stays above 6% or below 2% for three consecutive quarters.

• RBI must then send GoI a written report. It gives the reasons for the failure, the remedial action it proposes and the time it expects to take.

• The clause was first invoked in Nov 2022, after inflation stayed above 6% in Jan-Mar, Apr-Jun and Jul-Sep 2022.

• Who runs it: the Monetary Policy Committee (MPC) under s.45ZB, constituted in Sept 2016.

• It has 6 members: the Governor (chair, casting vote), the Deputy Governor in charge of monetary policy, one RBI officer, and 3 external experts appointed by GoI (4-year term, no reappointment).

• Quorum (the minimum number of members for a valid meeting) is four. The law requires at least 4 meetings a year. In practice there are 6.

• Transparency: a resolution after each meeting, minutes on the 14th day, and a Monetary Policy Report every six months.

• For example, the decision came on 5 Aug 2026 and the minutes on 19 Aug 2026 [5][6].

• Latest decision (Aug 2026): repo 5.25%, SDF 5.00%, MSF and Bank Rate 5.50%. The vote was unanimous [5]. The MPC kept a neutral stance [5].

Don't confuse with

• Monetary targeting (M3): this targets money supply growth, not inflation. India used it from 1985 on the Chakravarty Committee's advice. Inflation targeting targets CPI inflation directly.
• Goal independence vs instrument independence: India has instrument independence, so RBI chooses how to hit the target, for example the repo rate. India does not have goal independence, because GoI sets the target.
• Headline CPI vs core inflation: core inflation leaves out volatile food and fuel. India targets headline CPI-Combined, not core CPI and not WPI. The Aug 2025 paper raised the core option, but the 2026 renewal kept headline CPI [3][2].
• Flexible vs strict inflation targeting: strict IT looks only at inflation. Flexible IT, which India follows, also weighs growth. It uses the ±2% band and a glide path.

Prelims Hooks

• The target is set by the Central Government in consultation with RBI, every 5 years, under s.45ZA of the RBI Act, 1934 [3].
• The target is CPI-Combined (headline) 4% ±2%, retained for 1 Apr 2026 – 31 Mar 2031 [2]. It is not WPI and not core CPI.
• 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), added to the RBI Act by the Finance Act 2016. The MPC is under s.45ZB.
• Trap: the MPC decides only the repo rate and the stance. CRR and SLR stay with RBI.
• New Zealand (1990) was the first to adopt IT. In India, the Urjit Patel Committee (Jan 2014) recommended it.

Mains Points

• Credibility vs flexibility: the fixed 4% anchor has lowered and steadied inflation expectations since 2016. The ±2% band and the glide path let RBI absorb food and fuel shocks without crushing growth. The 2026 renewal of every feature shows the framework is now firmly settled [2].
• The headline vs core debate: food is a large share of CPI, and a rate hike cannot fix a vegetable-price shock. Supporters of core targeting say RBI should ignore such shocks. Supporters of headline targeting reply that food prices shape what households expect, so RBI must respond. The Aug 2025 paper opened the question, but GoI kept headline CPI [3][2].
• Accountability, independence and fiscal pressure (GS-II/GS-III):
• Accountability: the committee vote, published minutes and the written failure report make RBI answer to the elected government.
• Government control: GoI still sets the target, appoints half the MPC and holds s.7 powers to give RBI directions.
• Fiscal dominance risk: automatic monetisation through ad hoc T-bills ended with the 1994 and 1997 agreements. FRBM has barred RBI from buying primary G-secs since 2006. Even so, large deficits still push for low rates.
• Policy link: when the government borrows less, the MPC's job is easier and rate cuts reach borrowers faster.

Related concepts

• Flexible 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