| UPSC Relevance GS Paper III (Economy): Monetary policy, inflation targeting. GS Paper II (Governance): Institutional credibility, transparency. |
Why in News?
In 2016, India formally adopted an inflation targeting regime for monetary policy.The target was set at 4% inflation, with a tolerance band of ±2% (2% to 6%).The idea was simple: keep inflation low and predictable so that households and businesses can plan better.In 2021, the government extended this framework for another five years (till 2026).Now, with another review due, the RBI (Reserve Bank of India) has released a discussion paper on whether the current framework should continue, or if changes are needed.
This has sparked a debate: Should India stick to the 4% target, or make changes like targeting “core inflation” (which excludes food and fuel)?
Background: Why Inflation Targeting?
What is Inflation Targeting?
Inflation targeting means the central bank (RBI) sets a clear inflation goal (in India, 4%). All its monetary policy actions (like repo rate changes) are directed towards achieving that target.
Before 2016:
- Monetary policy was less predictable.
- Inflation often went above 10% (especially during 2009–2013).
- People lost confidence in RBI’s ability to control prices.
After 2016:
- RBI became more accountable — it had to ensure inflation stayed around 4% (within 2–6%).
- If inflation went above 6% or below 2%, RBI had to explain publicly why it failed and how it would fix it.
This shift brought credibility and discipline into India’s monetary policy.
Achievements of Inflation Targeting
1. Inflation Came Down
- Before IT (2016): avg. inflation 6.8%
- After IT: avg. inflation 4.9%
- Even during COVID-19, inflation stayed more under control compared to past crises.
2. Flexible in Crises
- RBI could cut interest rates in the pandemic to support growth.
- Yet, inflation didn’t go out of hand → shows balance of growth + price stability.
3. More Accountability & Transparency
- If inflation crosses 6%, RBI must explain to govt. why and how it will fix it.
- Example: In 2020–22, RBI explained global price shocks and its corrective steps.
- MPC meeting minutes published after 2 weeks → builds public trust.
4. Shared Decision-Making
- Policy is set by a 6-member MPC, not only the RBI Governor.
- Ensures diverse views and avoids concentration of power.
In short: Inflation Targeting has reduced inflation, allowed flexibility, improved transparency, and made monetary policy more democratic.
Current Debate: What the Discussion Paper Asks
1. Should the 4% Target Continue?
- Some say 4% is too strict for a developing country like India.
- Others argue it’s important to keep it at 4% to maintain trust and stability.
2. Should the Band Change?
- Right now, RBI works within 2–6%.
Debate:
- Make it wider (1–7%) → gives RBI more freedom.
- Make it narrower (3–5%) → makes RBI more accountable.
3. Headline vs Core Inflation
- Headline Inflation = includes food & fuel → affects daily life.
- Core Inflation = excludes food & fuel → less ups and downs.
- Globally, many countries use headline.
- RBI also prefers headline, since food & fuel matter most in India.
Example: If onion or petrol prices rise, people feel it immediately. Ignoring them would reduce trust.
4. Credibility Risk
- If the government keeps changing the target, people may stop trusting the RBI.
- Once trust is lost, inflation becomes harder to control.
Why Credibility Matters
- Monetary policy is not just about numbers, it’s about trust.
- If people trust RBI will keep inflation near 4%, they plan wages, savings, and loans accordingly.
- If credibility weakens:
- Businesses may raise prices more aggressively.
- Workers may demand higher wages.
- Inflation may spiral, even if RBI raises interest rates.
Example: In the 1970s, many Latin American countries lost central bank credibility → led to hyperinflation.
Thus, protecting credibility is more important than making short-term adjustments.
Way Forward for Inflation Targeting
- Keep Current Target (4% ± 2%)
The present system is working fine. No need to change it often. - Don’t Shift to Core Inflation
In India, food and fuel prices affect everyone. Ignoring them will reduce public trust. - Clear Communication
RBI should keep sharing MPC meeting notes and reports so people understand its decisions. - Other Reforms Needed-Inflation is not only about RBI’s policies. Improving agriculture, energy, and transport can reduce sudden price shocks.
- Focus on Stability-A steady, predictable system builds confidence. Changing rules frequently will damage trust in RBI.
In short: Stick to the current target, keep people informed, fix supply issues, and maintain stability.
Conclusion
India’s experience shows that inflation targeting works. It has brought down inflation, increased transparency, and strengthened RBI’s credibility.
- But credibility is fragile. If India frequently changes targets, shifts to core inflation, or dilutes the system, it risks losing public trust.
- As the article rightly says: “Any erosion of credibility must be avoided.”
👉 Therefore, India should continue with the 4% ± 2% framework, strengthen complementary reforms, and ensure monetary policy remains predictable, credible, and growth-supportive.
UPSC Prelims Practice question
Q1. With reference to India’s monetary policy, consider the following statements:
- Inflation targeting was formally adopted in India in 2016.
- The current inflation target is 4% with a tolerance band of ±2%.
- The Monetary Policy Committee (MPC) is chaired by the Finance Minister.
Which of the above statements is/are correct?
A. 1 and 2 only
B. 2 and 3 only
C. 1 and 3 only
D. 1, 2 and 3
Answer: A (1 and 2 only)
(MPC is chaired by the RBI Governor, not Finance Minister).
Q2. Consider the following pairs regarding inflation types:
- Headline Inflation – Excludes food and fuel prices.
- Core Inflation – Includes food and fuel prices.
- Consumer Price Index (CPI) – Commonly used for inflation targeting in India.
Which of the pairs given above is/are correctly matched?
A. 1 and 2 only
B. 3 only
C. 1 and 3 only
D. 2 and 3 only
Answer: B (3 only)
(Headline includes food & fuel, Core excludes them).
Q3. Which of the following best explains the importance of “credibility” in a central bank’s monetary policy framework?
A. It ensures that only fiscal policy decisions are credible.
B. It helps anchor public expectations about inflation, making monetary policy more effective.
C. It reduces the need for publishing monetary policy committee minutes.
D. It allows the government to directly control inflation.
Answer: B
UPSC Mains PRACTICE Questions
Q “Credibility is the cornerstone of monetary policy.” Discuss the significance of credibility in RBI’s inflation targeting framework. How can frequent changes in the inflation target risk undermining this credibility?( 15 MARKS,250 WORDS)
SOURCE- THE INDIAN EXPRESS
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