MPC Gets the Flexible Inflation Targeting Mandate Right

There comes a time in life of every institution when it must rediscover its identity by connecting to the soul and not be lost in the layers of perception (maya) it has curated over the years. The monetary policy committee happens to be one such institution in need of self-discovery as it completes its second term in practice and seeks a new mandate for fresh term ahead.

The MPC was born amidst lingering doubts of Indian central bank losing sight of nominal anchor with divergent readings of inflation on wholesale and retail level confounding policymakers in first half of 2010s. The erstwhile multiple indicator approach seemed to have run its course as it accorded too much discretion to monetary authority to act, or not, bringing it at odds with political authorities of the day.

It is worthwhile remembering D. Subbarao, the Reserve Bank of India Governor in 2013, while reacting to the then Finance Minister P. Chidambaram's grouse at the Central Bank not supporting the government in walking the growth path, by cutting repo rates sufficiently even as quarterly GDP growth had fallen to low single digits in early 2013. The finance minister pointed at wholesale price index-based inflation, the erstwhile nominal anchor, having come down markedly, allowing the space for central bank to act in favour of growth.  

Subbarao-led RBI, however, had difference of views as it chose to focus on bringing retail inflation as measured by variety of consumer price indexes down too before easing rates, further. The finance minister wasn't pleased as retail inflation was seen less susceptible to high interest rates given the higher weights of food in consumption basket. Subbarao once hoped that Finance Minister will thank in hindsight for the RBI's unyielding stance on inflation, even if it made him walk alone.

Subsequently, with new Governor, Raghuram Rajan, in office a quest for new nominal anchor begun, that could better reflect India's macroeconomic realities and build institutions less vulnerable to political pulls and pushes. The committee chaired by Urjit Patel, erstwhile Deputy Governor, recommended to adopt All India CPI based inflation as nominal anchor with 4% target in medium term and glide path to reach there. 

Also Read: Policy Reflects Growth Concerns

The government, subsequently, notified constitution of MPC, effective August 2016, and gave it a target of 4% headline CPI inflation with upper tolerance limit of 6% and lower tolerance limit of 2%. This regime thus got its name as ‘Flexible Inflation Targeting’. The CPI inflation average not adhering the target band for three consecutive quarters is deemed failure for MPC and it is required to explain reasons, remedial actions and time estimate by when it expects to achieve the inflation target with remedies it proposes. 

The mandate got renewed for another five years till March 2026. Barring one aberration, from January to September 2022, when CPI inflation averaged above 6%, the MPC has seen inflation remain in target band. However, MPC seems to have erred on the side of caution often, especially when it saw balance of risks to inflation on the upside. 

This was not without costs as country had to sacrifice growth every time real interest rates remain higher than neutral rate, which is loosely defined as interest rates consistent with stable inflation and steady growth.

In 2024-25, however, as growth started to fall from highs of 8% average in three years to 2023-24 to 6.5%, and CPI inflation remaining within target range, especially WPI inflation almost collapsing to zero, the memories of early 2010s could no longer be resisted. 

Also Read: Malhotra Keeps Rate Cuts in Play, but Will He Move Again?

This time, however, it was different as the institution of MPC meant it was no longer individual driven judgement of inflation being too high or growth being too low, but a collective wisdom of members to set economy on right course. Unfortunately, dissents among MPC members seemed to be a few and far between, even minutes often giving the MPC choices a pretence of groupthink.

With actual inflation undershooting the RBI projections consistently in 2025, the onus on the MPC to act in favour of growth became obvious. Governor Sanjay Malhotra acknowledged the space for MPC to accommodate growth in October as also in subsequent interactions with media. Further, as CPI inflation averaged below 2% in the second quarter of 2025-26 and expectations of third quarter inflation also being muted, the MPC ran the risk of three-consecutive quarter breach of lower bound of target, that is a failure to deliver on mandate.

However, as real GDP growth spurted to 8.2% in the July-September quarter following 7.8% print in April, market opinions got divided on next policy move from the central bank. A weakening rupee on the FPI outflows, amidst dimming hopes of the US-India trade deal in 2025, only further emboldened "pause" seekers in December review. A cut in repo rate could further aggravate pressure on the rupee with narrowing interest differentials vis-a-vis the US. With festive season seeing credit growth outpacing deposits, and the RBI intervening in forex market to support currency, liquidity situation complicated the rate transmission by banks. The "pause" option thus got support of bankers wary of thinning interest margins as deposit mobilisation remains a challenge.

This would have made sense in pre-inflation targeting era with central bank having multiple goals to achieve with multiple tools available. In FIT era, however, the MPC has a rather simple goal of inflation being in target range and with a single tool viz. setting repo rate, which has operational target of keeping call rates closer. The RBI is thus required to undertake liquidity operations to align call rate closer to repo rate. 

It is welcome to note that MPC didn't give-in to usual temptation of siding with caution, arguing inflation will return to 4% sometime, if not in near future. As it revised the inflation projections down, there remains space available for easing repo rate. Not cutting repo risks tolling growth just because it hit 8% mark for the first half of 2025-26. It is worth reiterating that MPC is given an inflation targeting mandate, and not growth targeting mandate. In other words, there is no upper-bound range for growth to get triggered unless it becomes a threat to securing inflation in target range.

Also Read: Goodbye Inflation, See You in Next Cycle

By acting with rate cut, the MPC has shown that it understands its mandate well and willing to err on side of optimism as much as side of caution. This repo cut has also given meaning to "neutral" stance as MPC being open to act on either side, which is pause, raise or cut, as situation unfolds in future. The commentary is dovish, leaving hope of another rate cut in future. The unanimous voting also is assuring as it signals rates to remain low for longer. 

The OMOs and USD-INR swap will ease the liquidity situation and support yields in bond market, thereby lowering cost of capital in economy. 

Taken together, while a 25-bps cut seems a routine act in central banking arena, the sheer timing and context makes it truly special, and worth celebrating even for purists of inflation targeting regime.