Inflation Targeting — Definition

Definition

Inflation targeting is a monetary policy strategy where the central bank sets a specific inflation rate as its primary goal and publicly commits to achieving it. In India, this framework was formally adopted in 2016, following recommendations from the Urjit Patel Committee.

The Reserve Bank of India (RBI) is mandated by law to maintain consumer price index (CPI) inflation at 4% with a tolerance band of +/- 2%. This means the RBI aims to keep inflation between 2% and 6%. The core idea behind inflation targeting is to provide a clear anchor for inflation expectations, which helps in stabilizing prices and fostering sustainable economic growth over the medium term.

When people expect inflation to remain stable, their wage and pricing decisions become more predictable, reducing uncertainty in the economy. The operational responsibility for setting the policy interest rate (the repo rate) to achieve this target lies with the Monetary Policy Committee (MPC).

This six-member committee, comprising three members from the RBI and three external members nominated by the government, meets at least four times a year to assess the economic situation and decide on the appropriate policy stance.

Their decisions are made by majority vote, with the RBI Governor holding a casting vote in case of a tie. The adoption of inflation targeting marked a significant shift from India's previous monetary policy approach, which relied on a 'multiple indicator' framework.

Under the old system, the RBI considered a wide array of economic variables, including inflation, growth, exchange rates, and money supply, without a single, explicit primary objective. This often led to ambiguity and made it difficult to assess the effectiveness and accountability of monetary policy.

The new framework, with its explicit target and a dedicated committee, enhances transparency and accountability. If the RBI fails to meet the inflation target for three consecutive quarters (i.e., inflation remains outside the 2-6% band), it is legally required to submit a report to the government explaining the reasons, proposing remedial actions, and providing an estimated timeframe for bringing inflation back within the target.

This accountability mechanism is a cornerstone of the inflation targeting framework, ensuring that the central bank remains focused on its primary mandate of price stability. The framework is termed 'flexible' because while price stability is the primary objective, the MPC also considers the objective of growth, especially when inflation is within the tolerance band, allowing for some discretion in policy formulation to support economic activity.