The trilemma monetary policy can’t ignore

India needs an informed debate on when and how financial stability and currency markets should shape monetary policy

- ANANTH NARAYAN

A foundational principle in international economics is the “impossible trinity” or “trilemma.” This asserts that a country cannot simultaneously maintain a stable exchange rate, allow full capital mobility, and pursue an independent monetary policy.

Putting inflation first: The January 2014 report of the Urjit Patel Committee shaped India’s monetary policy framework. The report recognised the trilemma and recommended giving precedence to flexible inflation targeting. It then emphasised the importance of allowing flexibility in exchange rate determination, while managing volatility through a combination of capital flow management (CFM) and macroprudential tools.

The report concluded that although international policy consensus was shifting towards multiple-target, multiple-instrument frameworks, India should first focus on reducing the then high inflation. The report noted that anchoring inflation expectations would eventually allow flexibility to pursue other objectives, without sacrificing price stability.

A clear nominal anchor — an inflation target — was proposed to discourage time inconsistency or discretion in policy, including due to pressures from interest groups.

Additionally, the report recommended that the Reserve Bank of India (RBI) build substantial foreign exchange reserves as a buffer against capital outflows. Fresh from the 2013 taper tantrum, the report also called for retaining flexibility for unconventional monetary measures, again reflecting the trilemma.

By March 2025, India’s total foreign exchange reserves (adjusted for outstanding forward sales) had more than doubled in absolute terms, compared to March 2013. However, in relative terms, the reserves were nearly the same at around 15 per cent of gross domestic product (GDP).