Context: India has completed a decade of formal inflation targeting (IT) by the Reserve Bank of India (RBI). The framework aims to maintain Consumer Price Index (CPI) inflation at 4%, with a tolerance band of ±2 percentage points. However, evidence presented in the article suggests that India’s Phillips curve is largely flat and household inflation expectations remain significantly above RBI projections, raising questions about the effectiveness and social costs of inflation targeting.
How Inflation Targeting Works
- The RBI primarily attempts to control inflation through demand management and anchoring inflation expectations.
- When inflation rises, the RBI can increase the repo rate, making borrowing costlier for commercial banks, which in turn raises lending rates.
- Higher borrowing costs discourage household consumption and business investment, reducing aggregate demand and thereby easing inflationary pressures.
- The second channel operates through inflation expectations: if households and firms expect higher future inflation, workers may demand higher wages and firms may raise prices in anticipation, potentially creating a self-reinforcing inflation process.
- Inflation targeting seeks to anchor these expectations around the RBI's projected inflation path, theoretically allowing inflation to fall without requiring a significant reduction in output.
New Keynesian Phillips Curve (NKPC)
- The New Keynesian Phillips Curve (NKPC) describes a relationship between economic activity/output and inflation, with higher output and employment theoretically generating greater inflationary pressure.
- The mechanism assumes that stronger economic activity improves workers’ bargaining power, enabling them to demand higher wages.
- Since firms treat wages as a major cost and add a profit margin to determine prices, higher wages translate into higher prices and inflation.
- Inflation expectations influence this relationship because workers negotiate wages based on the prices they expect to face in the future.
Simple Illustration
- Suppose a worker wants to purchase 5 kg of rice each month.
- If she expects rice to cost ₹100/kg, she would seek approximately ₹500 in wages for that requirement.
- If she expects the price to be ₹200/kg, she would seek approximately ₹1,000.
- Thus, expected prices influence wage demands, which influence firms’ costs and ultimately prices.
- In the conventional NKPC framework, stronger output and employment also strengthen workers’ bargaining position, causing wage demands—and therefore prices—to rise.
How Inflation Targeting is Supposed to Reduce Inflation
- If higher output causes higher inflation, policymakers can reduce inflation by suppressing demand, moving the economy down the Phillips curve; however, this comes at the cost of lower output and employment.
- Alternatively, if policymakers successfully lower inflation expectations, the Phillips curve can shift downward, reducing inflation without requiring a reduction in output.
- This expectation-management channel represents the theoretical attraction of inflation targeting because it promises lower inflation with a smaller output cost.
The Problem if India's Phillips Curve is Flat
- The effectiveness of inflation targeting depends partly on the assumption that a meaningful relationship exists between output and inflation.
- If India's Phillips curve is flat, reducing output may produce little or no corresponding reduction in inflation.
- If inflation expectations also fail to decline in response to RBI projections, the Phillips curve does not shift downward.
- In such a situation, monetary tightening can result in lower output and employment without a commensurate fall in inflation, creating a form of stagflationary outcome.
Evidence: India's Phillips Curve
- Research by the authors, published in the Economic & Political Weekly, finds India's Phillips curve to be flat under multiple specifications and methodologies.
- Their analysis uses monthly data on Index of Industrial Production (IIP) and CPI inflation for April 2012–March 2026.
- The best-fit trend between industrial output and inflation indicates that India's NKPC is at best flat, suggesting little systematic trade-off between output and inflation.
Why May India's Phillips Curve Be Flat?
- The conventional Phillips curve assumes that stronger economic activity increases workers' bargaining power and wages.
- This assumption may not hold in India because around 92% of workers are in the informal sector and largely lack effective bargaining power over wages.
- Such workers are predominantly price takers, rather than workers capable of negotiating higher wages as output or employment increases.
- Consequently, wages may not systematically rise with higher output or employment, weakening the wage-cost mechanism underlying an upward-sloping Phillips curve.
Inflation Expectations: Another Challenge
- Even if the Phillips curve is flat, proponents of inflation targeting could argue that lowering inflation expectations can shift the curve downward and reduce inflation.
- This requires households' inflation expectations to broadly align with the RBI's projected inflation trajectory.
- The RBI conducts surveys of Indian households regarding their expected inflation one quarter and one year ahead.
- According to the article's analysis, household expectations remained consistently higher than the RBI's projections, with the gap averaging around 4 percentage points.
- A similar gap exists when household expectations are compared with actual inflation, suggesting that expectations have not been effectively anchored to the RBI's inflation projections.
Implications for Inflation Targeting in India
- The evidence challenges two important assumptions supporting conventional inflation targeting: an upward-sloping Phillips curve and well-anchored inflation expectations.
- If output reductions do not significantly reduce inflation and expectations remain above the RBI's projected path, monetary tightening may impose substantial costs without producing proportional inflation gains.
- Higher interest rates can reduce investment, consumption, output and employment, disproportionately affecting workers who have limited bargaining power and depend on employment income.
- Therefore, using demand compression as the primary response to inflation may impose significant social and employment costs when inflation is driven by factors that monetary policy cannot easily address.
Broader Policy Debate
- The article argues that monetary policy should account for the structural characteristics of the Indian economy, rather than mechanically applying models based on assumptions that may not hold.
- India's large informal workforce, weak wage bargaining power and persistent divergence between household expectations and RBI projections complicate the conventional inflation-targeting framework.
- The key policy question is therefore whether reducing demand and employment is justified when the resulting reduction in inflation is small or uncertain.
- The article calls for greater attention to empirical evidence and changing economic realities rather than force-fitting India's economy into a conventional macroeconomic model.
