Monetary Policy, Inflation Targeting and the MPC

Objectives of monetary policy

Monetary policy is the RBI's management of interest rates and liquidity to achieve price stability while keeping in mind the objective of growth. That is the wording of the amended RBI Act.

Flexible inflation targeting (FIT)

Background: the Urjit Patel Committee (2014) recommended inflation targeting using CPI (Combined) inflation. The Monetary Policy Framework Agreement between the government and the RBI was signed in February 2015. The Finance Act 2016 amended the RBI Act to give FIT a statutory basis (Section 45ZA onward).

The target: CPI inflation of 4%, with a tolerance band of ±2% (2–6%). It is set by the Central Government in consultation with the RBI every five years:

• first period: 2016–21;
• renewed for 2021–26;
• the framework was due for review for the period after March 2026, and the RBI published a discussion paper on it in 2025.

Treat the post-2026 target as per the latest notification.

Failure: if average inflation stays outside the band for three consecutive quarters, the RBI must write to the government explaining the reasons and its remedial actions. This happened for the first time in November 2022.

Monetary Policy Committee (MPC):

• Six members: three from the RBI (the Governor as chair, the Deputy Governor in charge of monetary policy, and one RBI officer) and three external members appointed by the government for four years.
• Meets at least four times a year; in practice it meets six times.
• Decisions are by majority vote. The Governor has a casting vote in case of a tie.
• Minutes are published two weeks after each meeting.
• The first MPC meeting was held in October 2016.

Instruments of monetary policy

Quantitative (general) tools:

• Repo rate: the rate at which the RBI lends to banks against government securities under the Liquidity Adjustment Facility (LAF). It is the policy rate, and changes are signalled through it.
• Standing Deposit Facility (SDF): introduced in April 2022, it lets the RBI absorb liquidity without collateral. It replaced fixed-rate reverse repo as the floor of the corridor. The SDF rate is repo minus 25 basis points.
• Marginal Standing Facility (MSF): overnight emergency borrowing for banks. Banks can dip into their SLR holdings. The MSF rate is repo plus 25 bps and forms the ceiling of the corridor.
• Bank rate: aligned with the MSF rate; used for penal rates.
• Cash Reserve Ratio (CRR): the share of a bank's net demand and time liabilities (NDTL) that must be kept as cash with the RBI. No interest is paid on it. In 2025 the RBI announced a phased reduction of the CRR from 4% to 3%, completed by late 2025.
• Statutory Liquidity Ratio (SLR): the share of NDTL held in liquid assets (cash, gold, G-secs). The ceiling is 40% under the Banking Regulation Act. The SLR is 18%.
• Open Market Operations (OMOs): buying or selling government securities to inject or absorb liquidity durably.
• Variable Rate Repo/Reverse Repo (VRR/VRRR) auctions, for fine-tuning.
• Forex swaps, used for durable liquidity in 2025.

Qualitative (selective) tools: margin requirements, credit ceilings, moral suasion, direct action, and risk weights on specific loans. In November 2023 the RBI raised risk weights on unsecured consumer credit; it partly eased them in 2025.

Policy stance: "accommodative", "neutral" or "withdrawal of accommodation" (tightening) signals the future direction.

Recent policy path

• 2020: during the pandemic, the RBI cut the repo rate to 4.0%.
• May 2022 to February 2023: as inflation rose, it raised the repo rate by 250 bps to 6.5%.
• 2025: it began easing, cutting by 25 bps in February and April and 50 bps in June, taking the repo rate to 5.50%, and changed its stance to neutral.

Later decisions should be checked against the latest MPC statement.

Transmission

Transmission is the pass-through of policy rate changes to lending and deposit rates. Historically it was slow and incomplete: banks relied on sticky retail deposits, small savings rates are set administratively, and NPAs made banks cautious.

Reforms:

• Base Rate (2010).
• MCLR (Marginal Cost of Funds based Lending Rate, April 2016).
• External benchmark-based lending rates (EBLR), mandatory from October 2019 for floating-rate retail and MSME loans. Most are linked to the repo rate, which made transmission faster.

Understanding inflation

Measures:

• CPI (Combined): released monthly by the NSO, base 2012. Food and beverages carry a weight of about 46%. The RBI targets this index. A revised series with base year 2024 is being introduced; treat its date and weights as per MoSPI notification.
• WPI: released monthly by the Office of the Economic Adviser, DPIIT, base 2011–12. It has no services. It is useful for producer prices.
• CPI-IW (industrial workers), CPI-AL and CPI-RL (agricultural and rural labourers): compiled by the Labour Bureau. CPI-IW is used for dearness allowance.
• GDP deflator: the broadest measure.
• Core inflation: excludes food and fuel; it shows underlying demand pressure.

Types:

• Demand-pull inflation: excess demand.
• Cost-push inflation: higher input costs such as oil and wages.
• Built-in inflation: wage–price spirals and expectations.
• Imported inflation: rupee depreciation and global commodity prices.
• Structural food inflation: supply bottlenecks and monsoon dependence; the "TOP" volatility in tomatoes, onions and potatoes.

Related terms:

• Headline vs core.
• Disinflation: falling inflation.
• Deflation: falling prices.
• Stagflation: high inflation with stagnation.
• Skewflation: prices rising in a few items.
• Base effect: a low base last year makes this year's inflation rate look high, and vice versa.
• Phillips curve: a short-run trade-off between inflation and unemployment.

Effects of inflation:

• It hurts fixed-income earners and the poor (an "inflation tax").
• It benefits borrowers over lenders.
• It erodes export competitiveness.
• It creates uncertainty that reduces investment.

Moderate, stable inflation is considered good for growth. The RBI's research estimates India's growth-maximising "threshold" inflation at about 4%.

Analysis: has inflation targeting worked?

Supporters' view:

• Average inflation fell from about 9–10% (2009–2013) to around 5% after 2016.
• Expectations became anchored.
• The framework brought transparency and accountability.

Critics' view:

• India's inflation is food-driven and supply-side, which interest rates cannot fix.
• The RBI breached the band in 2020–22.
• Some, including the Economic Survey 2024, suggested excluding food from the target.

The RBI has argued that food inflation feeds into expectations, so headline CPI should remain the target.

Common prelims traps

• The reverse repo is no longer the floor; the SDF is.
• CRR is held with the RBI and earns no interest. SLR assets are held by banks themselves.
• Increasing the CRR reduces liquidity.
• WPI excludes services.
• The MPC's external members are appointed by the government, through a search committee headed by the Cabinet Secretary.

Quick self-test

1. *What happens to bond prices when the RBI buys G-secs through OMOs?* They rise, yields fall and liquidity increases.
2. *What is the corridor of the LAF?* From the SDF rate (floor) to the MSF rate (ceiling), centred on the repo rate.
3. *Which index does the RBI target?* Headline CPI (Combined).
4. *What is the base effect?* A statistical effect in which the year-ago price level, not current price changes, drives the measured inflation rate.

Practice: Mains question

*"Monetary policy alone cannot control food inflation in India." Discuss, with reference to the flexible inflation targeting framework. (250 words)*