Why Your Central Bank Wants Some Inflation

Introduction

For most of my life I assumed zero inflation was the unstated ideal central banks were working toward but hadn't achieved. It isn't. The RBI's actual target is 4%, with a tolerance band of 2 to 6%. This piece works through why that target isn't zero, who ends up bearing the real cost of a positive-inflation regime, and what a single monthly data point — the gap between headline and food inflation — reveals about how unevenly that cost is distributed.

Why not zero

Central banks worldwide, not just the RBI, generally target inflation in a small positive range rather than zero, for reasons that are well-established in monetary economics.

Deflation is a worse failure mode than moderate inflation. Falling prices increase the real burden of existing debt — the amount owed doesn't shrink even as the currency it's denominated in becomes more valuable, making repayment harder in real terms. Falling prices also give consumers a reason to delay purchases, waiting for further declines, which can suppress demand and trap an economy in a low-growth cycle that's difficult to escape through conventional monetary policy once it takes hold.

Wages resist nominal cuts far more than they resist inflation-driven real cuts. Workers and employers both tend to treat an explicit pay cut as a much bigger event than the same real-terms reduction delivered quietly through prices rising faster than pay. A small positive inflation rate lets real wage adjustments happen — which the economy sometimes genuinely needs — without requiring anyone to sign off on a nominal cut.

Price indices may overstate true inflation due to quality improvements not being fully captured, meaning a 0% measured target could represent slight deflation in the prices people actually experience.

India's monetary policy framework formalized this in the 2010s, moving to flexible inflation targeting with the medium-term CPI target of 4% ± 2% still in effect. The logic mirrors the global consensus rather than being an India-specific invention.

NAIRU and the limits of the model

The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the theoretical unemployment level at which inflation stays stable — push unemployment below it, and inflation is expected to accelerate. It's a useful modeling concept, but empirical estimates of NAIRU are highly uncertain and shift over time; it functions better as an input to policy models than as a precise, fixed target. In India specifically, the long-run relationship between unemployment and inflation has been found to be small and often statistically weak across multiple studies spanning 1955–2015, which limits how much explanatory power NAIRU-style models actually carry here compared to advanced economies where the relationship, while flattening since the 1990s, remains more measurable.

Who actually bears the cost

Positive inflation is not costless — it's a redistribution mechanism, and the direction of that redistribution depends entirely on what a household or business holds.

Cash holders and anyone relying on fixed nominal income lose real purchasing power every year inflation exceeds their return. Debtors benefit, since a fixed-rate loan becomes easier to repay in real terms as prices rise. Businesses with pricing power can pass rising costs to customers; those in competitive markets with fixed-price contracts absorb the squeeze instead.

The starkest version of this shows up in a single monthly data comparison. In March 2024, India's headline CPI inflation was 4.85%. Consumer Food Price Index (CFPI) inflation the same month was 8.52%. Because lower-income households spend a substantially larger share of their income on food, the "average" inflation figure meaningfully understates their actual experience while overstating the experience of wealthier households with more spending flexibility across categories. One reported number, two very different lived realities — and only the average one gets quoted in policy discussion.

Where households actually go to protect themselves

Because most Indian households hold the vast majority of their wealth in physical assets rather than financial ones, the standard advice — hold real or productive assets to outpace inflation — collides with structural access limits. Indian Household Finance Landscape research documents this concentration in gold and real estate as, in significant part, a rational response to inflation risk given limited practical access to diversified financial instruments, rather than simply a cultural preference disconnected from financial logic. State-level inflation volatility is positively associated with gold holdings specifically — households appear to be actively using gold as an inflation hedge, not just a store of sentimental value.

What this changes

Inflation targeting at 4% isn't a policy failure to hit zero. It's a deliberate tradeoff, chosen because the alternative — deflation risk and nominal wage rigidity — is worse for macroeconomic stability overall. But "better for macroeconomic stability overall" and "evenly distributed in its costs" are two separate claims, and conflating them obscures who's actually paying for the stability. A household with income concentrated in cash and no real-asset hedge bears more of the cost of this system than a household holding assets that rise with prices — which is most of the actual explanation for why gold and land dominate household portfolios in India, a pattern explored further in the next piece in this series.

FAQ

What is India's official inflation target? 4%, with a tolerance band of 2% to 6%, under the RBI's flexible inflation-targeting framework adopted in the 2010s.

Why don't central banks target 0% inflation? Primarily to avoid deflation risk (which increases real debt burdens and can suppress spending) and to allow real wage adjustments without requiring nominal pay cuts, which workers resist more strongly than equivalent inflation-driven reductions.

Does inflation hurt everyone equally? No. It erodes the real value of cash holdings and fixed nominal incomes while benefiting debtors and holders of assets that appreciate with prices. Lower-income households, who spend more on food and less on assets, tend to experience a higher effective inflation rate than the headline CPI suggests.

Why do Indian households buy so much gold? Research points to gold functioning as a practical inflation hedge — liquid, informally usable as loan collateral, culturally trusted — in a financial system where access to diversified financial instruments remains limited for most households.