Review of Monetary Policy Framework by RBI

Report Summary

• The Reserve Bank of India (RBI) released a discussion paper on “Review of Monetary Policy Framework” for public feedback.  Comments are invited by September 18, 2025.  

• In May 2016, the RBI Act, 1934 was amended to mandate a flexible inflation-targeting framework.  Under this, the central government sets a Consumer Price Index (CPI) inflation target every five years in consultation with RBI.  The central government also notifies an upper and a lower tolerance level for retail inflation.  Inflation outside the tolerance band for three consecutive quarters is considered a failure under the framework.

• In August 2016, a target of 4% inflation was notified for 2016–21 (First Review Period) with an upper and lower tolerance limit of 6% and 2% respectively.  In March 2021, these targets were retained for another five-years ending in March 2026 (Second Review Period).  A review of these targets is due by the end of March 2026.  Key observations of the RBI include:

• Performance of the inflation-targeting framework:  Average inflation declined from 6.8% during the four-year period before the adoption of the framework (2012-16) to 4.9% since its adoption.   Headline inflation remained within 2-6% range three-fourth of the time during the First Review Period and two-third of the time during the Second Review Period.  Headline inflation includes volatile components such as food and fuel.  During the Second Review Period, the COVID-19 pandemic and the Russia-Ukraine conflict led to inflation higher than 6%.  Around 94% of the time between April 2012 and April 2025, headline inflation deviation from its long-term trend fell within a range of ±2%.  Volatility in headline inflation, measured using standard deviation, has reduced from 2.3% during 2012-16 to 1.5% since 2016.

• Target inflation benchmark:  RBI observed that there are arguments that due to the volatile nature of food and fuel inflation, headline inflation should not be considered as the target measure.  Food and fuel inflation are also volatile due to supply shocks, and do not react to monetary policy.  However, food and fuel constitute more than 50% of the consumption basket in India.  RBI also observed that excluding these items may lead to policy biases and undermine policy credibility.  Further, persistent food inflation could affect core inflation (which excludes food and fuel prices) through higher wages, rents, and mark-ups.  It noted that all countries that pursue inflation targeting, focus on headline inflation except Uganda, which targets core inflation.

• Retaining or revising the 4% target:  The inflation targets have been around 2% in most advanced economies and 3-6% in major developing economies.  RBI noted that 4% is the desirable inflation rate for optimal macroeconomic conditions.  It observed that raising the target can be interpreted by global investors as a dilution of the framework, thereby weakening policy credibility.

• Appropriateness of the tolerance band:  The tolerance band incorporates flexibility into the monetary policy framework without deviating from the goal of price stability.  RBI noted that setting a tighter band improves monetary policy effectiveness, however, a wider band may weaken policy credibility.  It observed that in setting the tolerance band, threshold inflation can be the guide for upper tolerance level while the rate below which inflation can disincentivise production can determine the lower level.  Threshold inflation is the rate above which growth is adversely impacted by high inflation.  Many developing economies have moved towards 3-4% inflation target with a band of 1-1.5%.

• Fixed target vs range-based targeting:  Most countries that pursue inflation targeting, have a fixed target with or without a tolerance band.  RBI observed that range targeting provides flexibility to respond to economic shocks.  It is also in line with the trend of giving ranges based on scenarios in the face of increased global uncertainties.  It noted that transitioning from fixed to range-based targeting (4-6% or 3-6%) may undermine policy credibility and diminish fiscal policy discipline.