Does ‘inflation targeting’ work in India?

India has just completed a decade of inflation targeting (IT) as a formal policy framework of the Reserve Bank of India (RBI). Under this framework, the RBI is supposed to contain inflation at 4% within a band of (+/-) 2 percentage points. In this piece, we explain the theory behind inflation targeting and test it against the Indian experience.Managing demandsThe RBI seeks to control inflation through two channels: controlling demand and influencing the public’s inflationary expectations. The RBI flexes its policy rate of interest (called the repo rate), which is increased when inflation kicks in. This pushes commercial banks’ lending rates up.Households become wary of taking home or consumer loans, while businesses postpone decisions to build factories. Demand comes down and, as a result, so does inflation.The second route works through anchoring the inflationary expectations of the public at large. The assumption is that high expectations about inflation tomorrow influence inflation today because capitalists build these expectations into their current pricing decisions and workers into their wage decisions. Inflation is a self-fulfilling prophecy. So, if the RBI can somehow tether these expectations to its projected path of inflation, it can contain this prophecy. Both these routes work through a relationship called the New Keynesian Phillips curve (NKPC). This curve describes a relationship between the level of GDP and inflation in an economy. It is proposed that a rise in output leads to an increase in inflation. Prices are a markup over costs. For simplicity, let us assume wages are the only costs in an economy. Workers demand wages; capitalists add a profit margin to determine prices. If wages rise, prices follow suit. But why should wages rise with output?The wage-price negotiation process provides the key to understanding the NKPC. Consider a worker who would like to buy 5 kg of rice during a month for her family. Since she will not receive a sack of rice as her wage, she will have to settle for a money wage with which she can buy that amount of rice.The time difference between fluctuations in money wages and the purchase of rice makes expectations a key factor in the process. For example, if she expects the price of 1 kg of rice at the time of purchase to be ₹100, she would negotiate for ₹500 as wages to buy those 5 kg. But if she expects the price to be ₹200, she would ask for ₹1,000. Wage costs would go up (for the same bundle of wage goods), as would prices.A rise in output and employment, this framework argues, makes workers stronger and enables them to demand more rice — say from 5 kg to 6 kg — for the same number of hours of work. Thus, the wage demand curve rises with output (see panel (a) of Graph 1). Since prices are nothing but a markup over costs, the price curve (NKPC) has the same upward-sloping shape. On top of that, if the price expectations for rice were to change from ₹100 to ₹200, the wage demand curve, and the corresponding NKPC, would shift up for every level of output/ employment. In other words, the position of the NKPC is determined by expectations, and its slope by the bargaining power of workers and capitalists.If the economy were to behave in this manner, there are two obvious ways to bring inflation under control (see panel (b) of Graph 1). Slide the economy down along the NKPC curve (the trade-off range marked in the graph where both inflation and output fall) or manoeuvre workers’ expectations to a lower level across the board, so that the wage demand curve, hence the NKPC, shifts down, resulting in a fall in inflation with no impact on output. Expectation management is a less painful way of managing inflation. This is inflation targeting in a nutshell.All of this works well in theory. But what if the real picture of the Indian economy is depicted in Graph 2? What if the NKPC is flat and there is no trade-off between output and inflation? Additionally, what if people’s expectations do not match the RBI’s projections of lower inflation in the future — that is, the flat NKPC stays put instead of shifting down? Then, a policy of inflation targeting, which brings output down without lowering inflation at all, leads to a combination of lower output and flat stagflation (a left-pointed arrow in Graph 2).Let us put this theory to the test with Indian data. Is the Indian Phillips curve upward sloping?Our academic work published in the Economic and Political Weekly provides a more rigorous test of the Phillips curve, finding it to be flat under multiple configurations and methodologies. For the present purposes, a ‘first cut’ of that story is presented here. Chart 1 uses monthly data on industrial output, as measured by the Index of Industrial Production (IIP), and CPI inflation between April 2012 and March 2026. The best-fit trend line in Chart 1 shows India’s NKPC is, at best, flat.But why is there such a gap between reality and mainstream economic theory? Because the basic premise of a rising wage demand curve, and consequently NKPC, as shown in Graph 1, is incorrect. For economies such as ours, an overwhelming majority of workers (around 92%) do not have any bargaining power, let alone fixing wages. They are simply price takers. Wages do not rise with output/employment.Projections and expectationsEven if the Phillips curve is flat, IT enthusiasts would argue that shifting it down would still do the job. But for this to happen, people’s expectations should, by and large, match the RBI’s projections. What does the Indian data tell us? The RBI surveys Indian households about their inflation expectations a quarter and one year ahead. These expectations are plotted over this period against the RBI’s own projections. Chart 2(a) shows that expectations are consistently higher than the projections, that too, on average, by a margin of four percentage points. Even when expectations are plotted against actual inflation, the gap is similar (see Chart 2(b)). So, the expectations story is way off what is claimed to defend IT.John Maynard Keynes would have asked the RBI: ‘When facts change, I change my mind. What do you do sir?’ Unfortunately, the RBI does the opposite as it tries to force-fit a macroeconomic model to a world where the underlying assumptions of the model do not hold. In the process, it inflicts pain on the common people of this country by forcing them out of employment without any commensurate gain in controlling inflation.(The authors are a part of the DevMac (Development Macroeconomics) network, which seeks pluralism in Economics)