Does ‘inflation targeting’ work in India?
A decade into India's Flexible Inflation Targeting (FIT) framework, research finds that the country's Phillips curve — the theorised relationship between economic output/employment and inflation — is largely flat
Household inflation expectations, as measured through periodic surveys, remain consistently and substantially higher than the Reserve Bank of India's own inflation projections
These two findings together suggest that raising interest rates to control inflation may depress output and employment without producing a proportionate reduction in actual inflation
The analysis feeds into a broader assessment of whether the inflation-targeting model, built around a single instrument (the policy repo rate) and a narrow CPI target, is well suited to an economy where inflation is often driven by supply-side food and commodity shocks
Flexible Inflation Targeting (FIT) Framework — Origin and Legal Basis
India formally adopted Flexible Inflation Targeting following the recommendations of the Urjit Patel Committee (Expert Committee to Revise and Strengthen the Monetary Policy Framework), which submitted its report in January 2014. The framework was given statutory backing through the Finance Act, 2016, which amended the Reserve Bank of India Act, 1934 by inserting Sections 45ZA and 45ZB.
The article's questioning of whether inflation targeting "works" is a direct assessment of this 2016 framework roughly ten years after its adoption, examining whether its core transmission assumption (interest rates control inflation predictably) holds in the Indian context.
The Phillips Curve and Its Flatness in India
The Phillips curve models an inverse (or, in modern New Keynesian formulations, output-gap-based) relationship between inflation and either unemployment or the output gap — the theoretical basis for the claim that tightening monetary policy (raising rates, cooling demand) should lower inflation. A "flat" Phillips curve means changes in output or employment have little discernible effect on inflation.
Key Details
- A flat Phillips curve implies that monetary tightening depresses output and employment growth without delivering a commensurate fall in inflation, weakening the core rationale for using interest rates as the primary anti-inflation tool
- One structural explanation offered for India's flat curve is the dominance of the informal sector (a large share of India's workforce is informally employed), which limits wage-bargaining power and therefore the demand-side, wage-driven inflation transmission channel that the Phillips curve relies on in advanced economies
- India's inflation is frequently supply-side driven — food price shocks, weather/climate disruptions and global commodity (especially crude oil) price movements — channels that policy rate changes cannot directly address
- This is consistent with RBI's own "flexible" (not strict) inflation-targeting mandate, which explicitly allows some deviation to accommodate growth and supply-side considerations, rather than mechanically targeting CPI regardless of the source of inflation
The flat Phillips curve finding cited in the article is the empirical basis for arguing that the standard inflation-targeting transmission mechanism (rate hikes cooling demand and thereby inflation) may not operate as expected in India's structurally different, informal-sector-heavy and supply-shock-prone economy.
Inflation Expectations Anchoring and the RBI's Household Survey
A core assumption of inflation targeting is that a credible, transparent target anchors the public's inflation expectations close to the announced target, which in turn feeds into wage and price-setting behaviour and helps inflation converge toward target. RBI's Inflation Expectations Survey of Households (IESH), conducted periodically (bi-monthly, ahead of each MPC meeting), is the primary instrument used to track this anchoring.
Key Details
- IESH survey results have repeatedly shown that households' expected inflation runs several percentage points above both actual CPI inflation and the RBI's own projections, indicating expectations remain poorly anchored to the 4% target even a decade into FIT
- Poorly anchored expectations undercut the transmission logic of inflation targeting: if the public does not believe inflation will actually converge to 4%, wage and price-setting behaviour will not adjust as the framework assumes, reducing the credibility-based disinflation channel
- The MPC is statutorily required to explain, in a letter to the Government, any failure to keep CPI inflation within the tolerance band for three consecutive quarters — a built-in accountability mechanism under Section 45ZN of the RBI Act
- Comparable inflation-targeting central banks (e.g., the Bank of England) publish similar public/household expectation surveys, and gaps between expectations and targets are a recognised global critique of pure inflation-targeting regimes
The gap between household expectations and RBI's projections cited in the article is offered as direct evidence that the expectations-anchoring channel — the mechanism through which inflation targeting is supposed to work independent of, or alongside, demand suppression — has not functioned effectively in India.
- Committee that recommended FIT: Urjit Patel Committee (report submitted January 2014)
- Statutory basis: Finance Act, 2016 amending RBI Act, 1934 — Sections 45ZA (inflation target) and 45ZB (Monetary Policy Committee)
- Inflation target: 4% CPI, with a tolerance band of 2%-6% (+/-2 percentage points)
- MPC composition: 6 members — 3 from RBI (including Governor with casting vote) + 3 external members appointed by the Government
- Accountability mechanism: RBI must explain to the Government in writing if CPI inflation misses the band for three consecutive quarters (Section 45ZN)
- Year FIT framework completed roughly a decade in operation: 2016-2026
- Key finding: India's Phillips curve is empirically flat (2012-2026 data), and household inflation expectations remain persistently higher than RBI projections