Do it yourself

 The Reserve Bank of India adopted its current monetary policy framework in August 2016, under the governorship of Dr. Raghuram Rajan. This marked a major shift in the monetary policy formulation process in India.

In the pre-independence era, the function of monetary policy was mainly to maintain the sterling parity, with the exchange rate being the nominal anchor of monetary policy. Liquidity was regulated through open market operations (OMOs), bank rate and cash reserve ratio (CRR). After independence, India adopted the planning model of development, loosely based on the USSR model. The role of RBI monetary policy in this model was mostly to regulate credit availability, employing OMOs, set bank rate and reserve requirement in congruence with the planning objectives and development needs of the country.

The monetary policy framework witnessed a major shift between from mid 1980s to late 1990s. In 1985, on the recommendation of the (Dr. Sukhamoy) Chakravarty Committee, a new monetary policy framework was implemented. This framework was primarily based on targeting with feedback models. This framework was termed “Monetary Targeting with Feedback” as it was flexible enough to accommodate changes in output growth. The RBI was mandated to control inflation within acceptable levels with desired output growth. Further, instead of following a fixed target for money supply growth, a range was followed which was subject to mid-year adjustments.

Developments like deregulation of interest rates, integration of the Indian economy with the global economy, liberalization of the exchange rate system, etc. in the mid 1990s, warranted a change in the monetary policy approach. The RBI began to deemphasize the role of monetary aggregates and implemented a multiple indicator approach (MIA) to monetary policy in 1998 encompassing all economic and financial variables that influence the major objectives outlined in the Preamble of the RBI Act. This was done in two phases—initially MIA and later augmented MIA (AMIA) which included forward looking variables and time series models.

The current monetary policy framework of the RBI was adopted in 2016. This framework was based on the recommendations of the (Dr. Urjit) Patel Committee report. The Committee recommended a monetary policy framework that was largely based on the US FOMC model – flexible inflation targeting by RBI and a six-member statutory Monetary Policy Committee (MPC) for setting the policy repo rate. The key tools of monetary policy implementation under this framework have been the repo rate as the primary policy rate, supported by liquidity management tools like open market operations, standing deposit facility, and marginal standing facility.

The Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the RBI in February 2015 to formally adopt the flexible inflation targeting (FIT) framework. This was followed up with the amendment to the RBI Act, 1934 in May 2016 to provide a statutory basis for the implementation of the FIT framework. The Central Government notified in the Official Gazette dated August 5, 2016, that the Consumer Price Index (CPI) inflation target would be 4% with ± 2% tolerance band for the period from August 5, 2016 to March 31, 2021. The same tolerance band has however continued even after the March 2021 deadline.

The framework has, so far, helped anchor inflation expectations, reduce inflation volatility (from 7.5% pre-2016 to ~5% post-2016), and support growth, though challenges remain due to supply-side shocks (e.g., food and fuel prices) and external spillovers.

The RBI has now released a discussion paper listing proposals to suitably refine the extant monetary policy framework, to address emerging economic challenges, such as supply shocks, global uncertainties, and climate-related risks. The goal is to maintain price stability while supporting economic growth and financial stability in a dynamic global and domestic environment.

Proposed refinements

Inflation target and tolerance band: Retain the 4% CPI inflation target but review the ±2% tolerance band. RBI proposes (i) narrow the band (e.g., ±1.5%) for stricter inflation control; or (ii) maintain the current band but clarify its use to avoid misinterpretation as a range for persistent deviation; or (iii) Introduce asymmetric bands (e.g., tighter upper bound to prioritize high inflation control). RBI also suggests considering core inflation (excluding volatile food and fuel prices) as a secondary guide to better reflect demand-driven pressures. Public comments are invited by September 30, 2025, on key questions: Should the 4% target or ±2% band be revised?

Scope of inflation targeting: Continue using headline CPI as the primary metric due to its broad coverage and public relevance. Explore supplementary indicators (e.g., core inflation, inflation expectations, or sectoral indices) to address supply shocks like food price spikes, which are less responsive to monetary policy.

Monetary policy committee (MPC) processes: Enhance transparency through more detailed MPC minutes and forward guidance on policy intentions. Propose increasing the frequency of MPC meetings (e.g., monthly instead of bimonthly) to respond more swiftly to economic developments. Consider expanding external member expertise to include climate economics and global trade specialists.

Incorporating new challenges: RBI proposes to incorporate certain contemporary challenges in the process of setting monetary policy. These new challenges include - (i) Climate Risks: Integrate climate-related risks (e.g., weather-induced food price shocks) into the framework, potentially through adjusted forecasting models or stress-testing scenarios. (ii) Digitalization and Fintech: Account for the impact of digital currencies and fintech on money supply and monetary transmission. (iii) Global Spillovers: Strengthen coordination with global central banks to mitigate the impact of external shocks (e.g., U.S. Federal Reserve rate hikes, commodity price volatility).

Monetary policy transmission: Address lags and inefficiencies in policy transmission (e.g., slow pass-through of rate changes to lending rates) by improving banking sector competition and liquidity management. The RBI proposed exploring alternative tools, such as forward guidance or yield curve control, to enhance transmission in volatile markets.

Growth and financial stability: Balance inflation control with growth objectives, especially in the context of India’s post-pandemic recovery and structural reforms. Strengthen coordination between monetary and fiscal policies to avoid conflicting signals (e.g., high fiscal deficits undermining inflation control).

Rationale for Review

Changing economic landscape: Rising supply-side shocks (e.g., food and energy prices, climate disruptions) and global uncertainties (e.g., geopolitical tensions, monetary tightening in advanced economies) require a more adaptive framework.

Inflation dynamics: Persistent food inflation and volatile global commodity prices challenge the FIT framework’s effectiveness.

Stakeholder feedback: Public and expert consultations highlight the need for greater clarity on the tolerance band and flexibility in addressing non-monetary inflation drivers.

Expected Impact

Price Stability: A refined framework could better anchor inflation expectations, reducing volatility.

Economic Growth: Enhanced flexibility may support growth without compromising inflation control.

Resilience: Addressing climate and global risks could make the framework more robust to shocks.

Challenges: Narrowing the tolerance band or increasing meeting frequency may strain RBI resources and require careful calibration to avoid over-tightening.