Inflation

RBI’s Inflation Targeting Framework and the Debate on Continuity

Context: The existing flexible inflation targeting framework of Reserve Bank of India (RBI) is set to expire in March 2026. RBI had sought views from economists, market participants and other stakeholders on whether the current target, band, and measure should continue. Most respondents back the continuation of the existing structure. 

Relevance of the Topic: Prelims: Key Features of the 2015 Monetary Policy Framework. 

The monetary policy framework in India has evolved over the years. From relying on multiple indicators such as money supply and wholesale prices, the RBI shifted its focus to retail inflation in 2014. 

In February 2015, a new Monetary Policy Framework Agreement was signed between the Government of India and the RBI, which institutionalised inflation targeting in India.

Key Features of the 2015 Monetary Policy Framework

  • The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.
  • The framework is operated by the RBI, which uses instruments such as the repo rate to achieve the target.
  • The inflation target is fixed at 4% CPI inflation, with a tolerance band of +/-2 % (2-6%).
  • The inflation target is decided by the Government of India in consultation with the RBI, and is to be set once every five years. The current target has been notified till March 31, 2026.
  • The relevant measure of inflation is the Consumer Price Index (CPI-Combined) published by the National Statistical Office (NSO), Ministry of Statistics and Programme Implementation. 
  • The RBI is deemed to have failed in its mandate if inflation remains above 6% or below 2% for three consecutive quarters.
  • In case of such failure, the RBI must submit a written report to the Government explaining the reasons for the failure, remedial measures, and the time frame within which inflation will be brought back to the target.

Role of the Monetary Policy Committee (MPC)

  • The MPC was constituted in 2016 as a statutory body to set the policy repo rate required to achieve the inflation target.
  • It comprises six members: RBI Governor (Chairperson), the Deputy Governor in charge of monetary policy, one RBI officer nominated by the RBI Board, and three external members appointed by the Government.
  • Decisions are taken by majority vote, with the Governor having a casting vote in case of a tie.
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Performance of the Flexible Inflation Targeting (FIT) Regime (2016-2025)

  • Inflation has declined significantly since the adoption of FIT: from nearly 10% in 2012-13, CPI inflation is projected to average 3.1% in 2025-26, the lowest in the FIT era.
  • The framework has anchored inflation expectations of households and markets, thereby improving monetary policy credibility.
  • It has enhanced macroeconomic stability by reducing uncertainty for consumers and investors.
  • Low and stable inflation has supported sustainable growth, as extreme price fluctuations erode consumer purchasing power and discourage investment.
  • India’s adoption of FIT has brought it in line with global best practices, where most modern central banks follow inflation targeting frameworks.

Review of Flexible Inflation Targeting (FIT) Regime: 

The FIT regime requires a review every five years. The current review must be completed by March 2026. The RBI’s recent discussion paper has sought comments on key issues:

  • Whether monetary policy should target headline inflation or core inflation.
  • Whether the 4% inflation target remains optimal.
  • Whether the tolerance band (2-6%) should be revised.
  • Whether the target should be a point (4%) or a range only.

Former members of the Monetary Policy Committee (MPC) are largely in favour of retaining the targets as per the existing Flexible Inflation Target (FIT) regime and want to continue to focus on keeping headline Consumer Price Index (CPI) inflation at 4% in the medium term.

Also Read: Time to Review Inflation Targeting 

India’s Retail Inflation hits 8-year low of 1.55% 

Context: India's retail inflation rate has dropped to 1.55% in July 2025, its lowest rate since June 2017 (lowest level in eight years), driven by a drop in food prices. 

Relevance of the Topic:Prelims: Key facts about Retail Inflation; Consumer Price Index

Retail Inflation

  • Retail inflation reflects the cost of everyday goods and services bought for consumption purposes by households. It is measured by the Consumer Price Index (CPI).
  • Under the inflation-targeting regime (2016), the Reserve Bank of India is mandated to keep inflation within a 2%-6% band, and must explain to the government if it breaches either end for three consecutive quarters. 

Retail Inflation in India

  • India's retail inflation rate has dropped to 1.55% in July 2025, its lowest rate since June 2017.  
  • Inflation is well below the Reserve Bank of India's tolerance band of 2%-6% for the first time since January 2019.
  • Food prices have been the main driver for the drastic fall in inflation for the last eight months.
  • Concerns: A drop below 2% signals weak demand and can hurt farm incomes and rural spending. However, it is unlikely to trigger an immediate rate cut as policymakers may view the decline as temporary and driven by volatile food prices.
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Key government interventions to help lower Retail Inflation: 

The government’s strategic interventions have been pivotal in achieving this outcome. Key measures include:

  • Bolstering buffer stocks of essential food items, and releasing them periodically in open markets. 
  • Subsidised retail sales of staples like rice, wheat flour, pulses, and onions. 
  • Simplified import duties on critical food items. 
  • Stricter stock limits to prevent hoarding. 
  • Reduced GST rates on essentials have further eased price pressures. 
  • Targeted subsidies, such as LPG support under Pradhan Mantri Ujjwala Yojana and the Pradhan Mantri Garib Kalyan Anna Yojana.

What is the Consumer Price Index (CPI)?

  • CPI is an economic indicator that measures inflation at retail level (changes in the level of retail prices over time). 
  • It reflects how much households need to spend on a fixed basket of goods and services they typically consume, such as food, clothing, housing, and fuel. 
  • Compiled by: National Statistical Office (NSO), under the Ministry of Statistics and Programme Implementation.
  • Calculated using: base year 2012 
  • CPI is a key benchmark for targeting inflation, monitoring price stability, and guiding monetary policy decisions by the Reserve Bank of India. It also serves as a deflator in the National Accounts to measure real economic growth.

With inflation now at its lowest since 2017, India has reinforced macroeconomic stability and created an enabling environment for sustainable growth. However, the steep fall in food prices can lower farmer incomes and directly impact rural consumption demand. 

India’s WPI Inflation falls to 13-month Low

Context: As per the data released by the Ministry of Commerce and Industry, India’s wholesale inflation fell to a 13-month low of 0.85% in April 2025. It is down from 2.05% in March and 2.38% in February. 

The decline in inflation was largely due to a decline in prices in the fuel & power and primary articles segments, although the manufacturing sector continued to show resilience.

Relevance of the Topic: Prelims: Key facts about Wholesale Price Index (WPI). 

Wholesale Price Index:

  • WPI is an economic indicator that measures inflation at the wholesale level i.e., the average change in price of goods and commodities before they reach the retail or consumer market. 
  • It reflects price movements of basket of goods, including primary articles (food, oilseeds, minerals), fuel and power, and manufactured products. 
  • Compiled by: Office of Economic Advisor, Ministry of Commerce and Industry. 
  • Base year: 2011-12
  • Unlike CPI, WPI does not include services. WPI is used to monitor supply-side inflation and is a critical input for industry pricing, taxation and policy making. 

WPI Food Index

  • Sub-index of WPI. It is a combination of the food articles from the Primary Articles basket, and the food products from the Manufactured Products basket.

Measurement of Inflation in India: 

CriteriaWholesale Price Index (WPI)Consumer Price Index (CPI)
LevelMeasures Inflation at Wholesale levelMeasures Inflation at Retail Level
Who Calculates?Office of Economic Advisor, Ministry of Commerce and IndustryNational Statistical Office, Ministry of Statistics and programme Implementation
Base year2011-122012
CategoriesPrimary Articles, Manufactured products, Fuel and PowerFood and beverages, Tobacco and Intoxicants, Clothing and Footwear,Housing,Fuel,Miscellaneous- Education, Healthcare, Transportation etc.
Highest WeightageManufactured products > Primary Articles > Fuel and PowerFood and Beverages
Impact of increase in Food itemsLess impact on WPI as compared to CPI, since WPI provides higher weightage to manufactured products and lower weightage to Food items.Larger impact on CPI as compared to WPI since it gives more weightage to food products.
Services includedNoYes
Indirect Taxes Included?NoYes
Targeted by RBI?NoYes. The RBI is required to maintain CPI rate of inflation of 4% with a deviation of 2%.

India's Retail Inflation hits Six-Year Low

Context: Data released by the National Statistical Office (NSO) shows that retail inflation slipped to near six-year low of 3.16% in April 2025, primarily due to moderation in prices of food items including vegetables, pulses, cereals, meat and fish. 

Relevance of the Topic:Prelims: Key facts about Retail Inflation; Consumer Price Index

Retail Inflation

  • Retail inflation reflects the cost of everyday goods and services bought for consumption purposes by households. It is measured by the Consumer Price Index (CPI).
  • Retail inflation in India fell to a remarkable 3.34% in March 2025, the lowest since FY19. 
  • Under the inflation-targeting regime (2016), the Reserve Bank of India has an inflation target of 4% (with a leeway of 2% points on either side).
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What is the Consumer Price Index (CPI)?

  • CPI is an economic indicator that measures inflation at retail level (changes in the level of retail prices over time). 
  • It reflects how much households need to spend on a fixed basket of goods and services they typically consume, such as food, clothing, housing, and fuel. 
  • Compiled by: National Statistical Office (NSO), under the Ministry of Statistics and Programme Implementation.
  • Calculated using: base year 2012 
  • CPI is a key benchmark for targeting inflation, monitoring price stability, and guiding monetary policy decisions by the Reserve Bank of India. It also serves as a deflator in the National Accounts to measure real economic growth.
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Key government interventions to help lower Retail Inflation

The government’s strategic interventions have been pivotal in achieving this outcome. Key measures include:

  • Bolstering buffer stocks of essential food items, and releasing them periodically in open markets. 
  • Subsidised retail sales of staples like rice, wheat flour, pulses, and onions. 
  • Simplified import duties on critical food items. 
  • Stricter stock limits to prevent hoarding. 
  • Reduced GST rates on essentials have further eased price pressures. 
  • Targeted subsidies, such as LPG support under Pradhan Mantri Ujjwala Yojana and the Pradhan Mantri Garib Kalyan Anna Yojana.

With inflation now at its lowest since 2018–19, India has reinforced macroeconomic stability and created an enabling environment for sustainable growth. Easing inflation could raise domestic consumption and India’s sluggish industrial production. 

However, the steep fall in food prices can lower farmer incomes and directly impact rural consumption demand. The government must take measures to improve farmers’ income. 

RBI cuts Repo Rate by 25 bps

Context: RBI’s Monetary Policy Committee has decided to cut the repo rate by 25 basis points to 6%. The decision comes amidst heightened global economic uncertainty in the face of reciprocal tariffs announced by the US.  

MPC has slashed the GDP growth to 6.5% in FY26 from 6.7% projected earlier. Retail inflation is expected to be 4% in FY26. 

Relevance of the Topic:Prelims: Repo Rate; Reverse Reo Rate. 

Repo Rate and Reverse Repo Rate

  • Repo Rate: The interest rate that the RBI charges when commercial banks borrow money from it. 
  • Reverse Repo Rate: The interest rate the RBI pays commercial banks when they park their excess cash.

Reduction of Repo Rate: Promotes Economic Activity

  • When the RBI wants to encourage economic activity in the economy, it reduces the repo rates. 
  • This enables commercial banks to bring down the interest rates they charge (on their loans) as well as the interest rate they pay on deposits. Interest rates on home, personal, vehicle loans and deposit loans come down. 
  • This incentivises people to spend money as keeping their savings in the bank pays back a little less interest.
  • Businesses are incentivised to take new loans for new investments as new loans now become cheaper. 

Increase in Repo Rate: Control Inflation:

  • When the RBI wants to control inflation, it increases the repo rate. 
  • Banks charge more interest to their borrowers, as they have to pay more interest to borrow from the RBI. 
  • At a macro level, this inhibits people from borrowing money as well as from spending, which in turn reduces the amount of money in the market, and thus negates inflation.

Repo and Reverse repo rates are often referred to as the “benchmark” interest rates in the economy. Using these rates, the RBI sets the tone for all other interest rates in the banking system, and in the broader economy.

RBI could cut Repo rate for the first time in 5 years

Context: RBI’s Monetary Policy Committee (MPC) is expected to cut the repo rate by 25 basis points (bps) in its upcoming meeting (February 2025), from 6.5 per cent to 6.25 per cent. 

If implemented, this would be the first rate cut in nearly five years. This decision is influenced by easing inflation, government stimulus measures, and the need to boost economic growth.

Relevance of the Topic:Prelims: Repo Rate, External benchmark lending rate, Marginal cost of fund-based lending rate; RBI’s Inflation targeting framework

Repo Rate: 

  • Repo rate is the interest rate at which the commercial banks borrow money from the Reserve Bank of India (RBI) during a short-term liquidity crunch. 
  • Repo stands for ‘Repurchasing Option’ or ‘Repurchase Agreement’.
    • In the agreement, banks provide eligible securities such as Treasury Bills to the RBI, while availing overnight loans. They agree to repurchase securities at a predetermined price later from RBI. 
    • Thus, the bank gets the cash and the central bank the security.

How does Repo Rate affect the Economy?

  • Rise in inflation: 
    • During high levels of inflation, RBI increases the repo rate to bring down the flow of money in the economy. 
    • This curbs excessive spending, makes borrowing costly for businesses and industries, slows down investment and money supply in the market, and eases inflation.
  • Increasing Liquidity in the Market:
    • When the RBI needs to pump funds into the economy, it lowers the repo rate.  Consequently, businesses and industries find it cheaper to borrow money for different investment purposes. 
    • It also increases the overall supply of money in the economy. This ultimately boosts the growth rate of the economy.

Related Monetary Policy Tools:  

1. Reverse Repo Rate: 

  • Reverse Repo Rate is when the RBI borrows money from banks when there is excess liquidity in the market. 
    • The banks benefit out of it by receiving interest for their holdings with the central bank.
  • Reverse Repo Rate is a mechanism to absorb the liquidity in the market, thus restricting the borrowing power of investors.
  • During high levels of inflation in the economy, the RBI increases the reverse repo. 
    • It encourages the banks to park more funds with RBI to earn higher returns on excess funds. 
    • Banks are left with lesser funds to extend loans and borrowings to consumers.

2. Marginal Cost of Lending Rate (MCLR): 

  • MCLR is the minimum interest rate at which commercial banks can lend.
  • This rate is based on four components:
    • Marginal cost of funds
    • Negative carry on account of cash reserve ratio
    • Operating costs 
    • Tenor premium
  • MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up.

3. External Benchmarks Lending Rate: 

  • To ensure complete transparency and standardisation, RBI mandated the banks to adopt a uniform external benchmark within a loan category, effective from 1st October, 2019.
  • Unlike MCLR which was internal system for each bank, RBI has offered banks the options to choose from 4 external benchmarking mechanisms:
    • RBI repo rate
    • 91-day T-bill yield
    • 182-day T-bill yield
    • Any other benchmark developed by Financial Benchmarks India Pvt. Ltd.
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Factors influencing Repo Rate Cut Decision: 

  • Easing Inflation:
    • Retail inflation fell to 5.22% in December 2024, the lowest in four months. Lower inflation allows for monetary easing without major inflationary risks.
  • Union Budget 2025-26 stimulus:
    • Tax cuts and revised TDS limits aim to boost disposable income and consumption.
    • Increased consumer demand may require monetary support for sustained economic growth.
  • Liquidity Measures by RBI: Recent liquidity enhancement steps of RBI ensure banking system liquidity before a rate cut. RBI announced liquidity enhancement measures such as:
    • $5 billion forex swap.
    • ₹60,000 crore open market operations.
    • ₹50,000 crore variable repo rate operations.
  • Global Economic Uncertainty:
    • Trade tensions: US imposing tariffs on China, Canada, and Mexico, is creating instability in global trade. 
    • Impact on currency markets, with rupee hitting an all-time low of ₹87.29 per USD.
    • The RBI must balance rupee stability and domestic liquidity management.

Impact of Repo Rate Cut on Economy

  • Reduce Borrowing costs:
    • Repo-linked lending rates (EBLR): A cut in repo rate will reduce borrowing costs, making home, vehicle, and business loans cheaper.
    • MCLR-linked loans: Banks may also reduce rates for loans linked to the marginal cost of funds-based lending rate (MCLR). This will lead to lower lending rates for borrowers. 
    • The expected 25 bps rate cut will lower EMIs for borrowers.
  • Boost Economic Growth: A rate cut could stimulate investment and consumption, boosting GDP. 

The anticipated repo rate cut signals a pro-growth strategy while ensuring inflation remains in check. 

Balancing Monetary and Fiscal Policy

Context: The Union Budget 2025-26 has set the fiscal deficit target for 2025-26 at 4.4%. This will enable the Reserve Bank of India (RBI) to consider reducing interest rates to stimulate economic growth. 

Relevance of the Topic:Prelims: Monetary Policy Committee, Inflation targeting

Monetary Policy Committee (MPC)

  • The Monetary Policy Committee is a statutory body established under Reserve Bank of India Act, 1934 (as amended by the Finance Act, 2016). 
  • MPC is responsible for setting benchmark policy rate (repo rate) required to contain inflation, within the specified target level. 
  • Composition: The Central government is empowered to constitute a six-member MPC.
    • RBI Governor (ex officio chairperson)
    • Deputy Governor in charge of monetary policy
    • An RBI officer nominated by the Central Board
    • Three members to be appointed by the central government.
  • Decision-Making:
    • Quorum: At least four Members (at least one of whom shall be RBI Governor and, in his absence the Deputy Governor).
    • Decisions are based on a majority vote. 
    • In case of a tie, the RBI governor has the casting vote.
    • MPC decisions are binding on the Bank.

What is Inflation Targeting?

  • It is a monetary policy framework where the Central Bank aims to maintain the rate of Inflation within a targeted (pre-defined) range. 
  • India has adopted inflation targeting through the Monetary Policy Framework Agreement (MPFA) signed between the Government of India and the Reserve Bank of India in 2015.
  • India’s Inflation Targeting Framework:
    • India adopted Flexible Inflation Targeting (FIT) in 2016, with an inflation target of 4% (with a deviation of +/- 2%). 
    • The Consumer Price Index (CPI) serves as the key indicator.
    • The inflation target is set by the government in consultation with RBI every five years, under the amended RBI Act, 1934. 

Current Inflation Trends: 

  • Retail inflation declined to 4.5%-4.7% in January 2025 (down from 5.2% in December 2024).
  • Essential commodities prices fell by 2.4% in January, indicating a cooling trend.

Fiscal Policy: Maintaining fiscal discipline & controlling inflation

  • The Budget 2025 has maintained a fiscal deficit target at 4.4% of GDP to avoid excessive borrowing. Non-inflationary budget to ensure long-term economic stability.
  • Rationale:
    • Excessive spending can lead to high inflation and economic instability.
    • Fiscal prudence supports monetary policy efforts, ensuring economic predictability.

Coordination between Fiscal and Monetary Policy

  • Fiscal policy (government spending & taxation) and Monetary policy (RBI’s control over interest rates and money supply) need to work together to maintain economic stability.
  • The government’s disciplined spending approach allows the RBI to lower interest rates, when inflation is under control. Lower interest rates can boost borrowing, investment, and economic growth.
  • Government’s subtle Message to the RBI:
    • The government is signaling RBI that since inflation is under control, it may be a good time to start cutting interest rates.
    • RBI’s Monetary Policy Committee (MPC) will decide whether to cut repo rates in its upcoming meeting.
    • Lower interest rates make loans cheaper, helping businesses and individuals invest more.

A well coordinated approach between Fiscal and Monetary Policy is crucial for achieving economic growth and long-term economic stability.  

PDS posing challenges in CPI calculation

Context: The Ministry of Statistics and Programme Implementation (MoSPI) has floated a discussion paper in a process to revise the base of Consumer Price Index (CPI).  

Relevance of the Topic: Prelims: Key aspects about the Consumer Price Index (CPI). 

Major Highlights of the discussion paper: 

  • Objective: To revise the base year of CPI by updating weights and basket of CPI by introducing possible improvements in methodology of CPI compilation. 
  • Contention on PDS and free social transfers in context of CPI: The Ministry highlighted two major challenges in free distribution of PDS (Public Distribution System) items in context of CPI compilations:
    1. Mid Series Adjustments: How to address the reduction in the price of PDS items from positive value to zero or increase in price of PDS items from zero to some positive amount during an ongoing series?
    2. Inclusion in CPI basket at start of series: Should the free PDS items (which involve no out of pocket expenditure) be included in CPI basket or not remains a challenge. 

Challenges of including Free items in CPI

  • Various states and UT distribute various items like Kerosene in PDS for free of cost, which poses a challenge in calculation of such items as the out of pocket expenditure is zero for such items.
    • Existing norm- Such goods are assigned with the value of zero. Therefore, these items are effectively excluded from the CPI basket. 
    • IMF recommendation- International Monetary Fund suggests excluding such items from the index as the index should be restricted to monetary transactions only. Further, such transactions should be ignored as they do not generate any demand for money. 
  • Thus, including free items in CPI could underestimate inflation, while their exclusion might fail to reflect actual consumption patterns of households. 

Suggestions given in the discussion paper:

The discussion paper suggests three methods to deal with free PDS items:

  1. Zero value allocation- This method suggests that zero price to be allocated to items and adjusting the weight during the next update. (Method is proposed for next series of CPI)
  2. Redistribution of weight- Method suggests that the weight of items of such items in PDS to be redistributed as other items within the class or section. (Method is used in existing series)
  3. Redistribution across basket- Third method suggests redistribution of weight broadly over all items of basket.

About Retail Inflation Index in India

  • Consumer Price Index or CPI is the market basket index used to calculate the retail inflation in the country. 
  • RBI uses CPI (Combined) with base year 2012 to calculate the inflation. CPI (Combined) takes into account price changes in both urban and rural areas.
    • Base year is a reference year to calculate the value of goods. 
About Retail Inflation Index in India
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About Public Distribution System

  • PDS is a government led initiative designed to distribute food grains and essential commodities to economically weaker sections. 
  • Key objectives: Ensuring food security, stabilising food prices and reducing poverty. 
  • Notable schemes:
    • Antodaya Anna Yojana for the poorest of the poor households with heavily subsidised food grains. 
    • National Food Security Act 2013 covers 65% of the population of the nation, ensuring their Right to Food. 

Conclusion: CPI calculation is a barometer for the inflation in the nation, helping India to calculate its real growth prospects. To address the challenges in the calculation, the suggestions of the experts and agencies like the International Monetary Fund need to be incorporated. 

Household Consumption Expenditure Survey: 2023-24

Context: The Ministry of Statistics & Programme Implementation (MoSPI) has recently released the Household Consumption Expenditure Survey: 2023-24, based on the data collected during August 2023 to July 2024 from the entire country. 

Relevance of the Topic: Prelims: Key trends in the Household Consumption Expenditure Survey. 

What is the Household Consumption Expenditure Survey (HCES)?

  • HCES is designed to collect information on consumption and expenditure of the households on goods and services. 
  • Conducted by: National Sample Survey Office (NSSO), under the Ministry of Statistics & Programme Implementation. 
  • Utility of the Survey: It provides data required to:
    • Assess trends in economic well-being (measure poverty, inequality, and social exclusion).
    • Determine and update the basket of consumer goods and services and weights used for the calculation of the Consumer Price Index (CPI). 
  • The Monthly Per Capita Consumption Expenditure (MPCE) compiled from HCES is the primary indicator used for most analytical purposes.
  • Sample size: The estimates of MPCE of 2023-24 are based on the data collected from over 2.61 lakh households (both urban and rural) spread over all States and Union Territories in the country.
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Important Findings of HCES: 2023-24

  • Average MPCE in rural and urban India in 2023-24 has been estimated to be Rs. 4,122 and Rs. 6,996, respectively, without taking into account the values of items received free of cost by the households through various social welfare programmes.
    • In nominal prices, the average MPCE (without imputation) in 2023-24 increases by about 9% in rural areas and 8% in urban areas from the level of 2022-23.
  • Average MPCE with imputed values of items received free of cost through various social welfare programmes is estimated to be Rs. 4,247 and Rs. 7,078 respectively, for rural and urban areas.
  • Urban-rural gap in MPCE has declined to 71% in 2022-23 from 84% in 2011-12. It has further come down to 70% in 2023-24 that confirms sustained momentum of consumption growth in rural areas.
  • Consumption Inequality (measured in terms of the Gini Coefficient), both in rural and urban areas, has declined in 2023-24 from the level of 2022-23.
    • The Gini coefficient has declined to 0.237 from 0.266 in 2022-23 for rural areas and to 0.284 from 0.314 in 2022-23 for urban areas.
  • Non-food items (Rent, conveyance, clothing, bedding, footwear, entertainment) accounted for about 53% of household’s average MPCE in rural areas, up from about 47% in 2011-12, and 60% in urban areas, up from about 57%.
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Analysis of the Trends

  • India’s average household consumption spending rose about 3.5% in real terms through August 2023 to July 2024. This signals a decline in consumption inequality as well as a narrowing gap between urban and rural spending.
  • Decline in gini coefficient reflects reduction in consumption inequality across both urban and rural sectors.  Social welfare schemes like PM-KISAN, PM Garib Kalyan Anna Yojana have contributed to narrowing consumption inequality. 
  • Free items from the social welfare programs contributed significantly to the total expenditure, enhancing rural and urban MPCE. 
  • Dominance of non-food items to the household’s average monthly expenditure highlights India’s ongoing transition towards a consumption-led economy. For rural areas, it means a rise in living standard and access to services. For urban areas, it may indicate lifestyle inflation. 

Time to Review Inflation Targeting

Context: Despite extensive research and econometric studies, there is no conclusive evidence that inflation targeting is the most effective monetary policy framework. 

What is Inflation Targeting?

  • Inflation Targeting is a monetary policy framework where the Central Bank of a country aims to maintain the rate of Inflation within a targeted (pre-defined) range. 
  • India adopted inflation targeting through the Monetary Policy Framework Agreement in 2015, signed between the Reserve Bank of India (RBI) and the Central Government. 
  • Objective: RBI's primary objective would be to maintain price stability while keeping in mind the objective of growth. 
  • Target: The RBI is required to maintain inflation of 4% (with a deviation of +/- 2%), i.e., between 2% to 6%.

Why the Need to Review Inflation Targeting?

1. Inflation-Growth Dichotomy:

  • Inflation targeting relies on contractionary monetary policy (higher interest rates) to control inflation. However, such a policy would lead to an increase in rate of interest on loans, will raise borrowing costs, reduce private investment and consumption expenditure, thereby causing a decline in GDP growth rates. 

2. Persisting Inflation:

  • In Inflation targeting, controlling the money supply only alters demand-side inflation but does not address the inflation caused by supply-side constraints. 

E.g., Rise in prices of vegetables, pulses highlight supply side constraints, which are out of the purview of the RBI and hence they continue to erode household savings.

3. Inefficient Monetary Policy Transmission: 

  • Despite a cumulative hike in repo rate of 250 bps (during May 2022 to October 2023), banks revised their marginal cost of funds-based lending rate (MCLR) only by 152 bps. Hence, the cost of credit still remains high for prospective borrowers, thereby discouraging capital investment. 

Way Forward:

  • Shift to flexible inflation targeting: Post-Global Financial crisis, the dominant view around the world is that flexible inflation targeting (FIT), rather than pure inflation targeting, is more efficient for monetary policy formulation. By FIT, during times of extraordinary shocks (pandemics or financial crises), Central banks could temporarily adjust their inflation target to allow for more economic flexibility.
  • Address supply-chain constraints: Strengthening policy coordination with the government and undertaking structural reforms in the agriculture and developing efficient logistics and transport networks to address inflationary pressure due to supply-side shocks.

House Price Index (HPI)

Context: The All-India House Price Index (HPI) of the Reserve Bank of India rose by 4.34% as of September 2024. The rising HPI shows that the house prices are on the rise in India, despite high interest rates in the banking system and inflation. 

Relevance of the Topic: Prelims- House Price Index 

What is the House Price Index?

  • Released by: Reserve Bank of India 
  • Frequency: Published quarterly.
  • Base year: 2010-11
  • Coverage: The Index tracks the price movements of residential property in ten major cities in India. (Ahmedabad, Bengaluru, Chennai, Delhi, Jaipur, Kanpur, Kochi, Kolkata, Lucknow, and Mumbai)
  • Data Source: Official data of property price transactions collected from registration authorities of respective state governments. 
  • Based on these city indices, an average house price index representing all-India house price movement is also compiled. 

Utility of House Price Index:

  • Functions as an analytical tool for estimating:
    • Changes in the rates of Real estate and mortgage defaults
    • Housing affordability  
  • Used by policymakers and banks to assess the impact of monetary policy on the housing sector and assists in framing housing and urban development schemes. 

What is Inflation Targeting?

Inflation Targeting is a monetary policy framework wherein the Central Bank of a country focuses only on maintaining the rate of Inflation within a targeted range. 

It was first adopted by New Zealand and subsequently, a large number of countries including India have been following inflation targeting as their core element of monetary policy.

In case of India, the inflation targeting was introduced through the Monetary Policy Framework Agreement signed between the RBI and Government in 2015. 

As per terms of the agreement, RBI's primary objective would be to maintain price stability, while keeping in mind the objective of growth. The RBI is required to maintain a rate of inflation of 4% with a deviation of 2% i.e. inflation has to be maintained between 2% to 6%.

What Are Benefits of Inflation Targeting?

What is Inflation Targeting?
  • Spur investment rate: Flexible inflation target (4+2) would help in achieving sustainable price levels in the markets and as a result may increase savings rate in the economy. This may spur investment rate in the economy leading eventually to higher GDP growth.
  • Promotes export competitiveness: Stable price levels in an economy keeps a check on input prices of goods and services produced in the economy. This maintains the competitiveness of our goods in export markets thereby promoting export growth and reducing current account deficit.
  • Increase Foreign investments: Improved transparency in inflation targeting reduces investor uncertainty allowing them to predict changes in interest rates, and anchors inflation expectations. This will lead to an increased foreign portfolio and direct investments in the longer run.
  • Clear Policy Signal to Markets: The Inflation targeting explicitly states as to what would be the targeted rate of inflation in an economy. Such explicitly mandated targets bring in more clarity and predictability with respect to the rate of inflation and monetary policy formulation.
  • Autonomy and Accountability of RBI: As per the Monetary policy framework agreement, the RBI has been given complete autonomy in maintaining the rate of inflation within the mandated targets. If the RBI fails to maintain the Inflation within the target, then it would be required to submit in writing the reasons for its failure. Such a provision enables the RBI to enjoy autonomy and at the same time, enables the Government to have enhanced accountability over the actions of the RBI.
  • Empirical Evidence: Inflation targeting has been quite successful in some of the advanced economies such as the UK, New Zealand etc. These advanced economies have been able to maintain moderate rates of inflation for a much longer time leading to increased macro-economic stability.

What are Problems and Challenges with Inflation Targeting?

  • Disregards the Multi-faceted role of RBI: In a developing country like India, it is not practical for the central bank to focus exclusively on inflation without taking into account the larger development context. The RBI needs to balance between growth, price stability and financial stability.
  • Inflation-growth Dichotomy: Controlling inflation requires following contractionary monetary policy. However, such a policy would lead to an increase in rate of interest on loans leading to decrease in investment and consumption expenditure causing a decline in GDP growth rates. For example, during 2013-2015, the higher interest rates in the country on account of higher rate of inflation had led to decrease in the GDP growth rates.
  • Poor Monetary Policy Transmission: The Inflation targeting is more suited to the developed economies since the monetary policy transmission in such economies is quite efficient. However, in case of India, the monetary policy transmission is quite inefficient and this can in turn reduce the effectiveness of Inflation Targeting. In response to the cumulative hike in repo rate of 250 basis points during May 2022 to October 2023, banks have revised their marginal cost of funds-based lending rate (MCLR) only by 152 basis points.
  • Supply Side Constraints: Controlling the money supply only alters demand-side inflation and not inflation arising out of supply-side constraints. E.g. rise in prices of vegetables, pulses highlight supply side constraints which are out of the purview of the RBI and hence they continue to erode household savings.
  • No Clear link between Price Stability and Financial Stability: Prior to 2008 Global Financial Crisis, advanced economies were able to maintain moderate rate of inflation for a long term mainly due to adoption of Inflation Targeting. It was believed that Inflation targeting was responsible for overall macroeconomic stability of the country. However, the 2008 Global Financial Crisis has clearly proved that price stability alone cannot lead to financial stability and the excessive focus of the Central banks on price stability may lead to neglect of other crucial functions such as regulation leading to the economic crisis. 
  • Empirical Evidence against Inflation Targeting in India: The RBI was able to maintain a stable rate of Inflation within the mandated range before pandemic. However, in spite of a stable rate of Inflation, the Indian economy faced challenges on multiple fronts. The GDP growth rate reduced to 25 quarter low of 5% for the first quarter of financial year 2019-20. The unemployment increased to a 45-year high of 6.1%. There was a contraction in the manufacturing activity as evident in declining IIP. The agriculture sector stared at agrarian distress. All these clearly highlight that the inflation targeting has failed to promote growth and development.

Conclusion

  • Post-Global Financial crisis, the dominant view around the world is that flexible inflation targeting, rather than pure inflation targeting is more efficient for monetary policy formulation. During times of extraordinary shocks (e.g., pandemics or financial crises), central banks could temporarily adjust their inflation target to allow for more economic flexibility.
  • Additionally, strengthening policy coordination with the government and undertaking structural reforms in the agriculture and transport sector will help India address inflationary pressure due to supply-side shocks.

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