India’s monetary policy regime has served the country well in the decade since the Reserve Bank of India (RBI) adopted flexible inflation targeting. By setting a 4 per cent consumer price index (CPI) target within a ±2 percentage-point band, the RBI established a credible nominal anchor and helped bring inflation expectations under control. Yet, as the economy has evolved, the framework has begun to look dated. The structure of consumption has shifted markedly; the policy environment has become more complex; and the costs of anchoring policy on the wrong indicator have risen.
A sober reassessment points to the need for two changes. First, the anchor should shift from headline CPI to the “core” measure that strips out volatile food and fuel. Second, the tolerance band should be narrowed. Doing so would align monetary policy with the demand-side pressures it can actually influence, signal a stronger commitment to price stability and better fit the ambitions of a country seeking to become an advanced economy by 2047.
Headline CPI: A Fading Guidepost
The current framework rests on a CPI basket in which food carries a weight of about 46 per cent. That reflected the structure of Indian consumption when the basket was designed. But as real incomes have more than doubled over the past 15 years, household spending has diversified. The share of basic staples has declined, in line with the Engel curve and the National Sample Survey’s findings. Even within food, consumption has shifted towards higher-value items such as fruit and vegetables.
The inclusion of food and fuel creates considerable policy “noise”. Prices for these items are highly sensitive to factors that lie beyond the reach of interest-rate policy: erratic monsoons, unseasonal heat, export bans, and geopolitical shocks such as the war in Ukraine. Domestic fuel prices, notionally liberalised, still respond as much to political calculations as to world markets, with state-owned oil marketing companies often smoothing global volatility at the government’s behest.
Faced with such exogenous disturbances, the monetary lever is blunt. Raising or cutting the repo rate does little to alleviate a shortfall in onion supply or to offset a sudden spike in crude oil. Yet headline CPI forces the RBI to react to these swings, risking unnecessary policy tightening or easing and making communication harder.
Why Core Inflation Offers a Truer Compass
By contrast, core CPI—stripping out food and fuel—captures the demand-side price pressures monetary policy can more effectively influence. That is why, although few countries formally target core inflation, many central banks treat it as the main gauge of underlying pressures when setting policy.
India’s own data bear this out. Since the adoption of flexible inflation targeting in 2016, headline and core inflation have averaged 4.9 per cent and 5.0 per cent respectively—almost identical—but the volatility has differed sharply. The standard deviation of headline CPI has been about 1.5 percentage points, compared with only 0.9 points for core inflation.
The chart below shows the trend in core inflation, headline (CPI) inflation and RBI’s repo rate.
That lower volatility is not merely a statistical curiosity. It has direct implications for how policy should be framed:
* A narrower band. The present ±2 point corridor exists mainly to accommodate the food-driven swings in headline inflation. A switch to core would allow the MPC to adopt a tighter ±1.5 point band without constantly breaching it. That in turn would convey a firmer commitment to price stability and reduce the temptation to treat the ceiling as a soft target.
* A clearer anchor. Markets care as much about the midpoint of the target as about the band itself. A well-defined point target helps anchor inflation expectations and the real policy rate. The RBI’s repeated insistence on the 4 per cent figure during the pandemic shows the power of a clear focal point.
Critics argue that only a handful of economies—Uganda is often cited—explicitly target core inflation. But the question is not what others do; it is what best suits India’s structural conditions. With food and fuel prices so prone to exogenous shocks, a core-based target would yield a cleaner signal.
Moving the Anchor Downwards
India’s next policy review offers a rare chance to recalibrate not just the measure of inflation but the level at which it is targeted. As the economy aspires to advanced-country status by its centenary of independence, its monetary framework should converge towards international best practice. Most mature economies aim for about 2 per cent inflation.
There is evidence India could do likewise. The RBI’s own estimates suggest trend inflation has fallen from roughly 6.5 per cent 14 years ago to about 4.2 per cent today. That decline reflects structural shifts—greater competition, better supply chains, a more credible central bank—not merely cyclical luck.
Lowering the target would also bolster India’s macro-financial credibility.
# Global capital confidence. The Balassa-Samuelson effect implies a productivity-linked inflation premium in emerging markets, but relying on steady currency depreciation to deliver it is suboptimal. A lower anchor signals a determination to preserve the rupee’s real value, reassuring foreign investors about the predictability of returns.
# Fiscal discipline. The government’s medium-term commitment to reduce debt-to-GDP ratios rests on sustained growth rather than on inflating liabilities away. A lower inflation anchor reinforces that message, providing comfort to holders of Indian sovereign debt.
In short, lowering both the measure and the level of the target would place India firmly on a path of “mature” monetary policy.
Implementation: From Concept to Practice
What might such a recalibration look like in practice? One option would be for the RBI to announce a core inflation target of 3.5 per cent with a ±1.5 point band, establishing a corridor between 2.0 and 5.0 per cent. That would represent a modest but meaningful step: lowering the centre by 50 basis points and tightening the band by a quarter.
Such an approach would give the MPC a clearer guidepost, make policy decisions more transparent and reduce the scope for misinterpretation. It would also fit neatly into a longer-term trajectory of gradual convergence on a 2 per cent anchor over the next two decades—the same timeframe as the government’s “Viksit Bharat” vision of a developed India by 2047.
Of course, shifting the target is not without challenges. Statistical systems would need to ensure timely, high-quality core CPI data. Communication would need to emphasise that food and fuel inflation still matter for households but are not the right metrics for setting interest rates. And the RBI would need to manage the transition carefully to maintain credibility.
Yet the alternative—clinging to a framework increasingly out of sync with the economy’s structure—carries greater risks. Over time, policy missteps accumulate. Expectations drift. The nominal anchor loses its force.
A Significant Opportunity
Monetary frameworks do not change often. When they do, the decisions carry influence for decades. India’s adoption of flexible inflation targeting was such a moment. The next review offers another.
Switching from headline to core inflation and narrowing the band would not be a radical departure but a logical evolution. It would bring the policy instrument into line with the variable it can actually influence. It would provide clearer guidance to markets. And it would strengthen India’s claim to macroeconomic maturity at a time when its growth ambitions are high and its exposure to global capital flows is rising.
The long-term prize is a monetary regime that is not only credible but also tailored to India’s changing structure—a regime that anchors expectations firmly, dampens volatility and supports sustainable growth.
Conclusion
The RBI’s current inflation-targeting framework was designed for an earlier India, with a heavier reliance on food staples, more volatile prices and less credible institutions. The country that now stands on the cusp of middle-income status needs something different: a target that reflects underlying demand pressures, a narrower band that signals policy seriousness and a lower anchor that aligns with advanced-economy norms.
Adopting a core inflation target of 3.5 per cent with a ±1.5 point corridor would be the right start. Over the next 20 years, India could then converge gradually on a 2 per cent anchor, in step with its goal of becoming a developed economy by 2047.
This is not just a technocratic tweak. It is a generational choice about how India manages its price stability—a cornerstone of any credible growth strategy. By seizing the moment, policymakers can lay the foundation for a new, structurally sound phase of economic development.
(Akhilesh Tilotia is a public policy expert and author of two books on India’s economy and administration. Harsh Vardhan serves as an independent director on the board of Karur Vysya Bank.)
Views are personal and do not represent the stand of this publication.
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