Easy regime to communicate

The effectiveness of monetary policy in India's pre-inflation targeting regime was constrained by India-specific factors that affected the transmission of policy impulses through the interest rate channel.

- SOUMYA KANTI GHOSH

Some of the major factors were sustained fiscal dominance; a large informal sector and significant presence of informal finance; and bank behavior in pricing loan products.

Assiduous efforts by the government, the Reserve Bank of India (RBI), and banks have addressed all of these in the last decade.

The RBI adopted the flexible inflation targeting (FIT) agreement in February 2015 and amended the RBI Act in May 2016—with the inflation target set by the government in consultation with the central bank, and a possibility of revisiting it after five years. Accordingly, the government announced an inflation target of 4% with an upper tolerance limit of 6% and a lower limit of 2%. This band has so far not been changed.

A report card of the FIT's performance during the 10 years of its existence is important to look at for the future. Inflation has declined since the adoption of inflation targeting, compared to the preceding years. But what is important is that both core consumer price index (CPI) and CPI inflation have stayed within the band of 2-6%, with a few exceptions. The FIT's performance in the first five years, which included Covid-19, exceeded the inflation target due to a supply shock and also the creation of liquidity. However, both core and CPI inflation stabilized close to the upper band until July 2023, after which there was a rapid correction.