Inflation Targeting by RBI – Framework, MPC & Legal Basis
UPSC Economics Smart-Prep • GS III • Indian Economy & Monetary Policy
1. What is Inflation Targeting?
Inflation Targeting (IT) is a monetary policy framework in which the central bank (RBI) publicly announces an inflation target and then uses its instruments to keep actual inflation close to that target over the medium term.
Instead of targeting money supply or exchange rate, the RBI now targets the inflation rate (measured by CPI). The goal is to anchor inflation expectations, provide a clear nominal anchor, and improve transparency and accountability.
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2. Evolution – From Multiple Indicators to Flexible Inflation Targeting
Before inflation targeting, RBI followed a “multiple indicator approach” – looking at money supply, credit, exchange rate, growth, etc. There was no single explicit nominal anchor.
After high and persistent inflation episodes (especially post-2008), various committees (e.g., the Urjit Patel Committee) recommended moving to a Flexible Inflation Targeting (FIT) framework. This was adopted through amendments to the RBI Act.
graph TB A[Old Framework]:::node --> B[Multiple Indicators]:::note B --> C[No explicit inflation target]:::note D[New Framework]:::node2 --> E[Flexible Inflation Targeting]:::note E --> F[Explicit CPI target]:::note classDef node fill:#EBF5FB,stroke:#2874A6,color:#1B4F72; classDef node2 fill:#D4EFDF,stroke:#1E8449,color:#145A32; classDef note fill:#F5F6F7,stroke:#B3B6B7,color:#424949;
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3. Legal Framework – RBI Act & Monetary Policy Framework Agreement
Inflation targeting in India is backed by law. Amendments to the RBI Act, 1934 created:
- A formal monetary policy framework
- A Monetary Policy Committee (MPC) to set the policy rate
- An explicit inflation target notified by the Government in consultation with RBI
The Government notifies the inflation target (for a 5-year period) and RBI must explain if it fails to achieve this target for a specified time.
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4. The Monetary Policy Committee (MPC)
Decisions on the policy repo rate are now taken by a 6-member Monetary Policy Committee, instead of only the RBI Governor.
Composition
- 3 members from RBI
- RBI Governor – Chairperson
- Deputy Governor in charge of monetary policy
- One RBI officer nominated by the Central Board
- 3 external members – appointed by the Government of India
Decisions are taken by majority vote, with the Governor having a casting vote in case of a tie.
graph TB A[Monetary Policy Committee]:::root --> B[RBI Members]:::node A --> C[Govt Appointed Members]:::node B --> B1[Governor]:::note B --> B2[Deputy Governor]:::note B --> B3[One RBI member]:::note C --> C1[Three external experts]:::note classDef root fill:#D4EFDF,stroke:#1E8449,color:#145A32; classDef node fill:#EBF5FB,stroke:#2874A6,color:#1B4F72; classDef note fill:#F5F6F7,stroke:#B3B6B7,color:#424949;
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5. How Does Inflation Targeting Work in Practice?
Every two months, the MPC meets to decide the policy repo rate and the stance of monetary policy (accommodative, neutral, withdrawal of accommodation, etc.). The decision is based on:
- Current and projected CPI inflation
- Growth trends (GDP, IIP, credit, investment)
- External sector (exchange rate, capital flows)
- Financial stability indicators
If projected inflation is above the target band, RBI typically raises the repo rate or maintains a tight stance. If inflation is below target, RBI can cut the repo rate to stimulate growth.
graph TB A[Inflation Forecast]:::root --> B[MPC Decision]:::node B --> C[Repo Rate Change]:::node C --> D[Bank Lending Rates]:::note D --> E[Spending & Investment]:::note E --> F[Inflation Outcome]:::note classDef root fill:#D4EFDF,stroke:#1E8449,color:#145A32; classDef node fill:#EBF5FB,stroke:#2874A6,color:#1B4F72; classDef note fill:#F5F6F7,stroke:#B3B6B7,color:#424949;
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6. Why Inflation Targeting? – Advantages
Inflation targeting has transformed India’s monetary policy by creating a rule-based, transparent, predictable framework. It improves macroeconomic stability and anchors expectations.
Key Benefits
- Clear nominal anchor – CPI target provides direction to all economic agents.
- Transparency – MPC explanations, minutes, voting records increase accountability.
- Reduced inflation volatility – helps long-term investment & savings decisions.
- Better coordination with fiscal policy.
- Improves credibility of RBI in financial markets.
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7. Criticisms & Limitations of Inflation Targeting
Despite its success, inflation targeting is criticized for being too narrow and insensitive to growth, supply shocks, and structural bottlenecks—especially in developing countries like India.
Major Criticisms
- Over-focus on inflation may ignore growth and employment concerns.
- Supply-side inflation (food/fuel) cannot be controlled by interest rates.
- Rigid target band may constrain RBI during crises.
- Transmission mechanism in India is weak and slow.
- Frequent supply shocks (monsoon, global oil prices) limit MPC’s control.
graph TB A[Criticisms]:::root --> B[Supply Shock Inflation]:::node A --> C[Weak Transmission]:::node A --> D[Narrow Focus]:::node A --> E[Rigid Framework]:::node B --> B1[Food & fuel inflation not rate-sensitive]:::note C --> C1[Slow pass-through to lending rates]:::note D --> D1[Growth & jobs get less priority]:::note E --> E1[Limited flexibility during crises]:::note classDef root fill:#D4EFDF,stroke:#1E8449,color:#145A32; classDef node fill:#EBF5FB,stroke:#2874A6,color:#1B4F72; classDef note fill:#F5F6F7,stroke:#B3B6B7,color:#424949;
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8. Failure Condition – When RBI Must Explain to Government
The RBI must submit a formal explanation to the Central Government if it fails to meet the target for three consecutive quarters. This is legally mandated.
Failure Conditions
- If CPI > 6% for 3 quarters
- If CPI < 2% for 3 quarters
RBI Must Provide:
- Reasons for failure
- Corrective actions proposed
- Time period to bring inflation back within target
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9. Inflation Targeting vs Growth – The Debate
Critics argue that inflation targeting may reduce policy space for supporting growth. But supporters claim that low inflation is a precondition for sustainable growth.
| Argument | For Inflation Targeting | Against Inflation Targeting |
|---|---|---|
| Growth Impact | Stable inflation supports investment | High rates can slow growth |
| Flexibility | Flexible targeting allows balancing | Target band may feel restrictive |
| Supply Shocks | Helps anchor expectations | Cannot control food/fuel inflation |
| Transmission | Clear signaling to markets | Slow pass-through weakens impact |
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10. Smart Summary – Inflation Targeting in One Page
graph TB A[Inflation Targeting Summary]:::root --> B[Target 4% +/-2%]:::node A --> C[MPC 6 Members]:::node A --> D[Repo Rate Tool]:::node A --> E[Failure After 3 Qtrs]:::node B --> B1[CPI Combined only]:::note C --> C1[3 RBI + 3 Govt]:::note D --> D1[Transmission to rates]:::note E --> E1[Must explain to Govt]:::note classDef root fill:#D4EFDF,stroke:#1E8449,color:#145A32; classDef node fill:#EBF5FB,stroke:#2874A6,color:#1B4F72; classDef note fill:#F5F6F7,stroke:#B3B6B7,color:#424949;
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