Does inflation targeting work in India?

Why in the News

India has completed a decade of inflation targeting as the formal policy framework of the Reserve Bank of India (RBI). An empirical evaluation of that decade finds India’s New Keynesian Phillips Curve effectively flat on data from April 2012 to March 2026, meaning output and inflation do not move together as the framework assumes. The same evaluation finds household inflation expectations running consistently above the RBI’s own projections, on average by four percentage points. Both findings attack the framework at the same place, since inflation targeting works through exactly these two channels. The consequence claimed is that rate action compresses output and employment without a commensurate reduction in inflation.

How is inflation targeting supposed to work?

1. The mandate: The RBI is required to contain inflation at 4 per cent within a band of plus or minus 2 percentage points.
2. The demand channel: The RBI raises its policy rate of interest, the repo rate, when inflation rises. That pushes commercial banks’ lending rates up, households become wary of taking home and consumer loans, and businesses postpone building factories.
3. The expectations channel: Expectations of higher inflation tomorrow raise inflation today, because firms build them into pricing decisions and workers into wage decisions. Anchoring expectations to the RBI’s projected path is meant to break that loop.
4. The relationship both channels run through: The New Keynesian Phillips Curve links the level of output in an economy to inflation, and it is the mechanism through which either channel is supposed to deliver disinflation.

What does the curve assume about wages?

1. Prices are a markup over costs: Where wages are the main cost, a rise in wages passes into prices directly.
2. Output is assumed to strengthen workers: A rise in output and employment is assumed to let workers demand more in real terms for the same hours, so the wage demand curve slopes upward with output and the price curve follows it.
3. Expectations set the curve’s position: A worker negotiating a money wage today for goods bought later must price in expected inflation, so a higher expected price level shifts the whole wage demand curve and the price curve upward.
4. Bargaining power sets its slope: The position of the curve is determined by expectations and its slope by the bargaining power of workers and firms, so the framework’s two levers map onto those two properties.

What do the data show?

1. The test: Monthly data on industrial output, measured by the Index of Industrial Production (IIP), the volume index of factory, mining and electricity output, was plotted against CPI-C inflation, the combined rural and urban consumer price index on base 2012, for April 2012 to March 2026.
2. The construction: The output gap is measured as de-seasonalised IIP minus trend IIP, and the inflation variable as the first difference of CPI-C inflation, so the common time trend that produces spurious correlations is removed before any relationship is read.
3. The result: The best-fit trend line shows India’s curve is at best flat, meaning changes in the output gap are not associated with changes in inflation.
4. The finding is not an artefact of one method: The underlying academic work published in the Economic and Political Weekly finds the curve flat under multiple configurations and methodologies.

Why is India’s curve flat?

1. Most workers do not set wages: Around 92 per cent of workers have no bargaining power and are simply price takers.
2. The assumed link therefore breaks: Wages do not rise with output and employment, so the rising wage demand curve on which the whole relationship rests does not exist in this economy.
3. The consequence for policy: Compressing demand slides the economy along a flat line, which costs output without buying disinflation.

Do household expectations track the RBI’s projections?

1. What is surveyed: The RBI asks households for their inflation expectations a quarter ahead and one year ahead through its Inflation Expectations Survey.
2. The gap against projections: Household expectations run consistently higher than the RBI’s own projections, on average by a margin of four percentage points.
3. The gap against outturns: The same gap holds when expectations are plotted against actual inflation rather than against projections, so it is not an artefact of projection error.

What follows if both assumptions fail?

1. Route one is closed: Sliding the economy down the curve delivers falling output with no matching fall in inflation, because the line is flat.
2. Route two is closed: Shifting the curve downward requires household expectations to move with the central bank’s projections, and they do not.
3. The combination that results: Output falls, inflation stays where it is, and the outcome resembles stagflation rather than disinflation.
4. Who carries the cost: The burden of a demand compression that produces no disinflation falls on employment, in a workforce that has no wage bargaining power to recover it.

Challenges to flexible inflation targeting in India

1. The targeted index is driven by supplies the rate cannot reach: Food and fuel carry a heavy weight in the headline consumer price index, and a policy rate has no effect on a monsoon or a crude price. Eg. A rate increase cannot move vegetable prices during a supply shock.
   The Fix: Set the operational stance against a core measure and treat food spikes through buffer stock releases and import duty action.
2. Transmission reaches only part of the credit market: A repo change passes quickly to loans linked to an external benchmark and slowly to deposit rates and older loans. Eg. External benchmark linking covers floating rate retail and small business loans, not the whole loan book.
   The Fix: Extend external benchmark linking further and publish transmission data by loan category with each policy review.
3. The framework has no instrument for the employment cost: The statutory objective names price stability first and growth second, so a flat curve leaves the entire adjustment burden on output. Eg. A rate cycle records its inflation outturn but not the jobs foregone during it.
   The Fix: Publish an estimate of the output and employment cost alongside every rate decision, so the trade-off is on the record.
4. Expectations are formed outside the central bank’s reach: Households form price expectations from grocery bills rather than from a policy statement, so communication does not anchor them. Eg. The survey’s respondents run persistently above the projected path.
   The Fix: Broaden the expectations survey to report by income group and publish the survey design, so the anchoring claim becomes testable.

Conclusion

The dispute is no longer about the level of the target but about whether the mechanism connecting the policy rate to prices exists in this economy. The unresolved tension is between a framework designed for a market where wages respond to output and a labour force where almost all workers are price takers. Ten years of data are now available to settle it, and the statutory review of the framework is where that evidence has to be confronted. Whether the central bank revises its model or continues to force-fit it is the thing to watch.

Matching Previous Year Question

“[2024, GS3, 10 marks] What are the causes of persistent high food inflation in India? Comment on the effectiveness of the monetary policy of the RBI to control this type of inflation.”