Do Actions Match Words? Reassessing the Taylor Rule in an Emerging-Market Context

Backward-looking Taylor rules, widely used to characterize central bank behavior, can misrepresent policy when central banks base decisions on forecasts. This mischaracterization affects the assessment of credibility, defined as alignment between a central bank’s words and actions. We examine this issue in the context of India’s adoption of flexible inflation targeting (FIT) in 2015. Text analysis shows that the Reserve Bank of India’s (RBI) communication became more inflation-focused and forward-looking after FIT adoption. Yet backward-looking Taylor rules show no robust increase in responsiveness to realized inflation, suggesting lack of credibility. This misalignment disappears when we analyze policy-relevant information through a forward-looking lens. Using the RBI’s real-time inflation and output forecasts, we find significant responsiveness to expected inflation post-FIT. Hybrid reaction functions show that post-FIT policy responds to both expected and realized inflation. The analogous evolution in communication and conduct points to the RBI’s credibility. More broadly, our results demonstrate that hybrid reaction functions may better characterize emerging-market central bank behavior than purely backward- or forward-looking specifications.