How to make FIT fitter this time

Economic Times

24-07-2025

Agencies Representational India's flexible inflation targeting (FIT) framework is up for review in early 2026, having been last reviewed in 2021. Some finetuning can make it more robust and enhance efficacy of the communication channel, which is critical to influence expectations of market participants and households.
Band music Maintain headline CPI inflation midpoint target at 4% with +/-2% band. But also add a core inflation target of 4% +/-1% as an additional anchor to decide on the monetary policy stance. If headline CPI inflation and core inflation remain above 5% on a secular basis, then RBI will need to tighten its monetary stance to bring inflation back to the target. Level of the output gap should be considered while making the final decision.
While the shift in monetary policy focus to CPI from WPI has been welcome, the current framework has led to an excessive emphasis on point-estimate headline CPI figures, at the cost of giving less importance to core inflation, a more reliable indicator of underlying inflation momentum. This overemphasis on headline CPI inflation delayed the rate-cutting cycle to February. If core CPI inflation had been given equal emphasis, then the rate-cutting cycle could have started ideally from October 2024. Now, the sharp drop in headline CPI inflation, led by lower food prices, is causing an opposite effect, with expectations rising that RBI can cut rates further as headline CPI inflation has dropped closer to 2% levels.Again, if core inflation is given equal weight in deciding the monetary policy stance, along with headline CPI inflation, then the justification for further rate cuts should not arise, with core CPI inflation currently being above the 4% mark. Reacting solely to the headline CPI inflation trajectory, which gets impacted readily by volatile vegetable prices, raises the risk of policy error, which can be avoided by giving equal weight to core CPI inflation, while keeping headline CPI inflation as the nominal anchor for the FIT framework.This is not to suggest replacing headline CPI inflation anchor with core CPI inflation. Instead, accord core CPI inflation equal weight alongside headline CPI inflation to make FIT more robust. Otherwise, monetary policy, at most times, may remain hostage to volatile price trends of key vegetables like tomatoes, onions and potatoes. Take a new stance The monetary policy rate stance should be aligned with the liquidity stance to improve efficacy of monetary transmission. When the former is accommodative, then the latter should be as well, with short-term rates possibly remaining closer to standing deposit facility (SDF) rate - but not below SDF rate, to maintain sanctity of the liquidity adjustment facility corridor.
When the monetary policy rate stance is neutral, then the liquidity stance ought to be neutral as well, with short-term rates remaining closer to the repo rate. With RBI having changed its stance to neutral in June, it's not surprising it has announced variable rate reverse repo (VRRR) auctions to maintain short-term rates between SDF and repo rate. And in a rate hike cycle, the liquidity stance needs to be restrictive, so that short-term rates remain between repo and marginal standing facility (MSF) rates, to have an effective monetary transmission. Such an alignment between the rate and liquidity stances is easy to appreciate and can also serve as an effective signal from RBI's view regarding the turning point of monetary policy cycles. Dot plots With the inflation targeting framework now being in place for nearly a decade in India, MPC members could be given additional responsibility for providing their forecasts of interest rates (anonymously, of course) in the form of 'dot-plots' over different time horizons, like in US Fed. This will likely add to policy credibility, and sharpen the tool of forward guidance in signalling to the market about the potential turning point of monetary policy cycles. (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.) Elevate your knowledge and leadership skills at a cost cheaper than your daily tea. Can victims of Jane Street scam be compensated by investor protection funds?
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