MBF 2025-wl-8273-Managing the Impossible Trinity in an Inflation Targeting Regime

The view that the neglect of financial stability by central banks was one of the prime reasons for the Global Financial Crisis in 2008/09 gave way to flexible inflation targeting. In this setup, central banks are mandated with the additional responsibility of maintaining financial stability along with price stability. Over the last two decades, many emerging market economies, including India, have embraced FIT. In delivering on their inflation target, these economies confront the challenge of the impossible trinity – the difficulty of conducting an independent monetary policy while maintaining an open capital account and a fixed exchange rate. They have managed the impossible trinity through a variety of instruments including forex market intervention, macroprudential policy, capital controls, and occasionally monetary policy. An additional complicating factor is that the monetary policy committee typically has a narrow mandate of only price stability whereas the central bank has broader responsibilities including growth and financial stability in these economies. This can be a potential source of tension.