Ajit Ranade: RBI must not abandon headline inflation as its target

It was a landmark reform that established price stability as the primary goal of monetary policy. It was formalized through a contract signed between the government and the central bank which set a Consumer Price Index (CPI) inflation target of 4%, the mid-point of a tolerance band of 2-6%, and gave RBI a statutory mandate by changing the RBI Act. This institutionalized transparency and accountability aligned India’s approach with global best practices. It was reaffirmed in 2021.

Also Read: RBI at fork in the road, experts back chasing headline inflation

RBI is now weighing the idea of switching to a core inflation target. That would be a mistake. The current framework remains optimal for India in both the international and domestic contexts.

The first reason stems from the target’s communication and credibility. Headline inflation, which includes prices of food and fuel, is far better understood and more tangible for the public. The direct impact of food and energy prices on daily expenses means people associate ‘inflation’ with the headline measure, not the more technical core measure that excludes these volatile elements.

CPI inflation is understood by people as a gauge of their own cost of living. Adopting core inflation as the target would risk confusion, damaging the credibility of the regime and reducing the effectiveness of RBI’s communication. 

It would weaken the clarity of the messaging. Worse, households and businesses may perceive RBI as unresponsive to the inflation they face if food and fuel prices spike but its core remains steady. They might view RBI as ignoring common hardships or shifting goalposts during price shocks. Public confidence depends on policy aiming at the lived experience of inflation. When targets are transparent, relatable and consistently communicated, expectations become firmly anchored.

Also Read: Should rate-setting panel track headline or core inflation? RBI stirs debate

The second reason relates to international evidence. Over 36 countries practise inflation targeting and almost all use headline CPI. No significant inflation-targeting country has abandoned this regime entirely. Some supplement inflation targeting with other objectives, but do not replace headline CPI targets. Using CPI as the target enhances transparency, aligns with public perceptions and supports clear communication. Core inflation is universally used for internal analysis and guidance, but not as an anchor. Any divergence from this practice could jeopardize RBI’s hard-won credibility.

A third reason is potential market confusion. Financial markets and analysts commonly track headline CPI. If RBI pivots to core inflation, aligning expectations and signalling future rate changes could become more complicated, possibly increasing volatility or misinterpretation. The disconnect would make it harder for RBI to anchor inflation expectations.

Also Read: Mint Quick Edit | Inflation: Below target, above the worry line

A fourth reason is the proposed change in CPI construction. Beginning February, the CPI basket will be revised, reducing the weightage of food items—currently more than half the index—by up to 8 percentage points. This will make headline CPI less volatile and more closely track underlying inflation trends, mitigating one of the key arguments for switching to a core measure. Hence, the regime’s perceived ‘problem’ is already being addressed.

A fifth reason is the principle of ‘If it ain’t broke, don’t fix it.’ India’s framework has delivered lower and more stable inflation since adoption; inflation outcomes have improved versus earlier decades of high volatility and persistent price rise. With the expected modification of the CPI basket, headline inflation’s weaknesses will reduce, not increase. Changing the anchor when the regime is working well risks undermining confidence—a poor move amid the current economic uncertainty.

Also Read: Himanshu: Low inflation masks a growing problem of fruitless farming

The demand for shifting from headline to core inflation as a target stems from the volatility of food and fuel prices. For instance, vegetable prices can jump up and down at double-digit rates in a short period, causing the headline index to swing. Food prices in India are seen to be affected by supply shocks and considered immune to monetary policy action. Hence, some have argued for removing them from the formal target. The Economic Survey 2023-24 too had suggested exploring core inflation targeting to avoid monetary policy being used to address supply-induced food price spikes, which can lead to over-tightening that hurts growth. 

But RBI itself has cautioned against ignoring food prices, since persistent food inflation can spill over to core inflation through wage and price expectations. Monetary policy cannot dismiss second-round effects of supply shocks. Shifting away from headline inflation could be viewed politically as distancing monetary policy from the inflation experienced by the common citizen, putting the credibility of RBI and trust in it at risk.

On balance, India’s existing inflation targeting regime, with headline CPI as its anchor, will best serve our objectives of growth, stability and credibility. The regime, which has been in place for nearly 10 years, is well understood and respected internationally. It incorporates flexibility and will soon be structurally strengthened by the CPI revision. To alter it now—especially to target core inflation, which the public cannot relate to—would introduce confusion and risks without compensatory benefits.

The author is senior fellow with Pune International Centre