Industry Odisha Bureau, Sep 07 : India has completed a decade of formal inflation targeting. The RBI aims to contain inflation at 4%. Its tolerance band spans plus or minus two percentage points. Controlling demand remains one central policy channel. The RBI can increase policy rate of interest when inflation rises. Higher borrowing costs then ripple through household and business decisions.
The demand channel works through commercial lending rates. When the RBI raises its repo rate, banks follow. Households grow cautious about home and consumer loans. Businesses often postpone factory expansion and investment plans. This dampened borrowing is meant to cool demand. Lower demand, in theory, translates into lower inflation.
Inflation expectations form the second policy channel. The RBI seeks to anchor what people expect prices to do. Businesses may build expected inflation into pricing decisions. Workers may build it into wage negotiations. Anchoring expectations to RBI targets is therefore critical. Persistent expectations become, in this model, self-fulfilling.
Both channels rest on the New Keynesian Phillips Curve. This framework links economic output with inflation levels. Rising output theoretically strengthens workers’ bargaining position. Stronger bargaining can push wage demands higher. Higher wage costs then feed into consumer prices. This wage-price link underpins the standard theoretical curve.
Indian evidence complicates this textbook relationship considerably. Research examining monthly IIP and CPI data finds otherwise. The study covers April 2012 through March 2026. Under multiple methodologies, India’s Phillips curve appears flat. This suggests weak evidence of a genuine output-inflation trade-off.
One explanation lies in workers’ limited bargaining power. Around 92% of workers reportedly cannot negotiate wages upward. They function largely as price takers in the economy. This challenges the assumption that wages rise with output. It offers one account for the curve’s flatness.
Household inflation expectations add another complication. The RBI surveys households on expectations three months and a year ahead. These expectations consistently exceed the RBI’s own projections. The average gap runs around four percentage points. A similar gap appears against actual inflation outcomes.
This mismatch raises questions about anchoring effectiveness. If expectations resist RBI projections, transmission may weaken. Combined with a flat Phillips curve, this creates a theoretical risk. Demand reduction could lower output without proportionately lowering inflation. Some economists describe this scenario as stagflation risk.
Higher interest rates already carry output and employment costs. Reduced borrowing weakens business investment and household spending. Employment can suffer when economic activity slows down. These costs matter more if inflation barely responds.
None of this suggests inflation targeting is fundamentally broken. But it raises questions about India-specific policy transmission. The debate underscores a need for domestic economic realism. Demand management alone may not fully explain India’s inflation dynamics.
