From a Rule-Based Monetary Policy to a Judgment-Based One

“Central banking is as much about judgment as it is about rules.” That observation, often echoed in policy circles, feels particularly relevant today. If the last few years have shown anything, it is that rigid frameworks struggle in a world defined by uncertainty. Wars, climate shocks, and volatile commodity prices have made inflation less predictable and far less controllable by textbook methods.

For the Reserve Bank of India (RBI), this has triggered a gradual but important shift, from a strict inflation-targeting regime to a more flexible, growth-aware and stability-focused approach.

When India formally adopted flexible inflation targeting in 2016, it marked a turning point. Anchoring inflation around 4% (with a tolerance band of 2–6%) brought credibility and discipline to monetary policy.

It helped tame the high inflation of the early 2010s and reassured global investors that India was serious about macroeconomic stability. Over time, this framework largely worked. Inflation stayed within the target band for most years, with only temporary breaches during crises.

But the world that this framework was designed for has changed dramatically. Today’s inflation is not always a result of excess demand or loose monetary conditions.

Instead, it is increasingly shaped by supply disruptions, many of them global and beyond the RBI’s control. The Russia-Ukraine conflict disrupted energy and food supply chains, tensions in the Middle East continue to keep oil markets on the edge, and climate change has made agricultural output more volatile. In such a world, inflation is not just an economic variable; it is a geopolitical outcome.

This is where the limitations of CPI-based targeting in India become clear. A large share of India’s inflation basket comprises food and fuel, categories that are inherently volatile. Food alone accounts for a significant portion of household consumption, and its prices are influenced more by monsoons and supply chains than by interest rates.

Recognising this distortion, policymakers are already working on revising the CPI basket, with the food weight expected to be reduced significantly to better reflect current consumption patterns and reduce volatility.

The latest Economic Survey reinforces this point. It highlights how inflation trends in recent years have been heavily influenced by food and fuel dynamics, with a sharp decline in headline inflation in 2025 largely driven by easing prices in these segments.

In fact, average headline inflation fell to as low as 1.7% during April–December 2025, one of the lowest readings in the CPI series. This was not because monetary policy suddenly became more effective, but because supply-side conditions improved, aided by good agricultural output, lower commodity prices and policy interventions on food supply.

At the same time, underlying inflation tells a very different story. Core inflation, which excludes food and fuel, has remained relatively stable, generally hovering around moderate levels even when headline inflation swings sharply.

This divergence creates a policy dilemma. If the RBI reacts aggressively to headline inflation spikes driven by vegetables or crude oil, it risks slowing down the broader economy unnecessarily. If it ignores inflation altogether, it risks losing credibility and hurting consumers.

This tension is at the heart of the RBI’s evolving approach. Officially, the inflation-targeting framework remains intact. But in practice, the central bank has shown increasing flexibility in how it interprets and responds to inflation data.

Its recent policy stance reflects this shift. Even as inflation dropped sharply in 2025, at times falling well below the 4% target, the RBI did not rush into aggressive tightening or easing. Instead, it maintained a calibrated approach, balancing growth needs with inflation risks.

This balancing act is closely aligned with the broader fiscal stance of the government.

The Union Budget and Economic Survey point to India’s medium-term growth potential of around 7%, even in a challenging global environment. Fiscal measures, including tax rationalisation and support for consumption and investment, have complemented monetary policy in sustaining growth.

In fact, coordinated fiscal and monetary actions such as tax cuts and rate adjustments have helped boost demand and investment momentum despite global headwinds.

The implication is clear: monetary policy in India is no longer operating in isolation or with a single objective. It is increasingly part of a broader macroeconomic strategy that balances inflation control with growth and financial stability.

Another important factor shaping this shift is the recognition that monetary policy works with a lag. By the time interest rate changes affect inflation, the original shock, say a spike in vegetable prices may already have reversed.

This makes a purely reactive, inflation-focused approach less effective. Instead, the RBI is increasingly looking at trends, persistence, and broader economic signals rather than just headline numbers.

Recent inflation data supports this more nuanced approach. After touching record lows of around 0.25% in late 2025, inflation has gradually normalised to around 3% in early 2026, well within the RBI’s comfort zone. This stability has given the central bank room to focus on sustaining growth rather than reacting to short-term volatility.

What is emerging, therefore, is a more “structuralist” view of inflation, one that recognises the role of supply chains, global factors and domestic structural constraints. Instead of treating inflation as purely a monetary phenomenon, the RBI is acknowledging that it is often shaped by factors beyond its immediate control.

This does not mean that inflation targeting will be abandoned. Far from it. The 4% target continues to serve as an important anchor for expectations and policy credibility. But it is increasingly being treated as a guiding benchmark rather than a rigid rule.

As India moves closer to the next review of its monetary policy framework, the direction of travel is evident. The future is likely to involve a more flexible interpretation of inflation targeting, one that allows the RBI to look through temporary supply shocks, focus on underlying inflation trends, and support growth when needed.

In many ways, this marks the evolution of India’s monetary policy from a rule-based system to a judgment-based framework. And in a world where inflation can be driven as much by geopolitics and climate as by domestic demand, that shift may not just be necessary, it may be inevitable.

Disclaimer: This is an authored article. The views expressed are personal and do not necessarily reflect those of the publisher or the editorial team.

About the Author: The author is a former Chairman of the Bombay Stock Exchange and Promoter and Managing Partner at Ravi Rajan & Co. LLP.