Flexible Inflation Targeting (FIT): Is it time for a rethink?

26 Aug 2025 , 12:57 PM

TIME FOR REVIEW OF FLEXIBLE INFLATION TARGETING

RBI adopted flexible inflation targeting (FIT) regime in May 2016, with an agreement to review it once every 5 years. In May 2016, the target inflation was set at 4% with a range +/- 2%. That means, the inflation had a tolerance range between 2% and 6%. When the FIT framework was reviewed after 5 years in March 2021, the same levels were retained as RBI did not want to experiment too much. The third review comes up in March 2026.

RBI has already circulated a discussion paper covering 4 key questions. Firstly, should RBI focus on target headline inflation or target core inflation. Secondly, whether 4% inflation target is fine for a fast growing Indian economy or calls for a revision. Thirdly, should the tolerance band stay at +/- 2% or should it be modified. Lastly, should target inflation still be retained, or should there just be a band that offers flexibility and credibility?

• MAKING A CHOICE – HEADLINE INFLATION VERSUS CORE INFLATION

Core inflation is the structural component of headline inflation, which excludes volatile items like food and fuel. It is the residual inflation item. Being more structural, core inflation is more amenable to targeting. However, in a country like India, food inflation is critical as it has 48% weight in inflation basket and cannot be ignored. There are arguments both ways.

It can be argued that targeting food inflation in India can improve welfare outcomes, since per capita income levels are very low. Global experience is that the bias is towards headline inflation targeting rather than core inflation targeting. Also, in the aftermath of the COVID pandemic, core inflation shot up due to supply chain constraints. In such situations, the core inflation is beyond the control of the government, and targeting may not help.

• IS 4% INFLATION TARGET STILL A WORKABLE TARGET?

Inflation targets in last few years have been set at 2% for most advanced economies while for emerging economies it is more in the range of 3-6%. If one looks back at the last 10 years, the average inflation was 3.9% between 2016 and 2020, which is very close to the FIT. However, between 2020 and 2024, the average inflation was closer to 6.0%; more due to the supply chain constraints caused by the pandemic. However, since 2025, the average inflation has again come below 4%. In the Indian context, 4% is a sort of optimal level where price stability, jobs, and GDP growth are achieved.

• IS IT TIME TO RETHINK THE TOLERANCE BAND LEVELS?

One of the experiences of inflation in India is that the expected inflation tends to influence spending propensities of people. If the government were to lower that range from the current 2%-6%, consumers may get too optimistic about falling inflation; perhaps wrongly so. By taking the range higher, RBI may send a signal that inflation is set to rise and that may trigger spending caution in consumers.

The empirical evidence is that the current range of 2% to 6% has stood monetary policy in good stead even in a very tough pandemic situation. While there have been persistent cases of breaching the upper target in 2022 and 2023, it was a global problem. The one question is whether India can narrow the band from 4% to 2%, although that will come at the risk of frequently breaching the band amidst volatile macros.

• DOES FIT NEED SPECIFIC TARGET, OR IS A BAND ENOUGH?

Many countries have set a range for inflation, without specifying a central figure. One very logical argument against a pure band is that even when a specific target is done away with, people look at the central figure as the median target. If the range of 3-5%, then 4% will  be presumed as the target and if the range is 3-6%, then 4.5% is the presumed target. However, when the RBI defines a range and a central figure, it has a lot more credibility.

For now, the discussion paper is up on the website of the RBI for public comments. However, it looks like the changes to the FIT framework, if any,  would be marginal!