Analysis: India RBI Signals Change in Reaction Function Amid Elevated Inflation

By Sophia Rodrigues

The Reserve Bank of India recently introduced a date-based forward guidance to signal a change in its reaction function in an environment of elevated inflation and to reiterate its accommodative policy stance.

In doing so, it has become a rare central bank to use two forms of forward guidance concurrently. And this, together with a strengthening in its existing guidance, suggests monetary policy will remain accommodative for longer.

At the October 9 monetary policy decision, the RBI said it will maintain the accommodative monetary policy stance at least during the current financial year and into the next year. This is a date-based forward guidance the RBI put in addition to its event-based guidance that the accommodative stance will be continued as long as necessary to revive growth on a durable basis and mitigate the impact of the COVID-19, while ensuring inflation remains within the target.


Forward guidance is a monetary policy tool used to influence policy expectations. While it is particularly useful when interest rates are at the effective lower bound and hence widely used in the current environment, some central banks have used it even before the global financial crisis.

There are three common forms of forward guidance – open-ended, data-dependent, and event-dependent.

Of these, the most common form is an event-dependent FG where a central bank commits to maintaining easy policy until one or more economic outcomes are achieved. For example, inflation reaches its target band, or jobless rate falls to a certain level.


The RBI’s current accommodative policy stance has been in effect since June 2019 when it changed from neutral and later in October it introduced FG saying it has “decided to continue with an accommodative stance as long as it is necessary to revive growth, while ensuring that inflation remains within the target.”

In March this year, the RBI tweaked the guidance to reflect the stance will be kept accommodative to also “mitigate the impact of COVID-10 on the economy.”

At the monetary policy meeting last week, the RBI not only strengthened its event-based FG but also introduced a second date-based guidance.

The RBI said the stance will be continued until growth revives “on a durable basis” and “at least during the current financial year and into the next financial year.”


The introduction of date-based guidance is an important one because it is meant to communicate a signal of change in the RBI’s reaction function. This means the RBI will not react to inflation or growth in a way it is otherwise expected to react. In other words, the RBI will not tighten policy within the timeframe suggested even if inflation or growth surprises to the upside.

This is largely in the context of elevated inflation but could also include upside risk of a strong revival in growth. It is therefore no coincidence that the RBI also included durability of growth in the guidance.

By signalling a change in the reaction function, the RBI is aiming to reduce uncertainty about the future path of interest rates.

This is because if inflation remains elevated or above the target band for longer, there is a risk that market will start expecting policy hikes. This would be especially so if it is also accompanied by strong growth rebound because it would have then met conditions of the previous guidance of “as long as it is necessary to revive growth, while ensuring that inflation remains within the target.”

In the statement, the RBI said supply disruptions and associated margins/mark-ups are the major factors driving up inflation and it has decided to look through the “current inflation hump as transient and address the more urgent need to revive growth and mitigate the impact of COVID-19.”

While the RBI expects inflation to ease gradually towards the target over the December and the March quarters, it has also noted the risks remains balanced.

Data published earlier this week showed CPI inflation rose 7.34% y/y in September and was above the RBI’s 2% to 6% target band for six months in a row.


The Reserve Bank of Australia in another central bank that currently uses dual forward guidance – date-based, and state-based.

The event-based guidance states that the RBA will maintain highly accommodative policy setting as long as is required and will increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2% to 3% target band.

The RBA’s date-based guidance is through its target on three-year government bond yield which is a signal to the market that the cash rate will be at the current level for at least three years.