The Economic Survey preceding this year’s Union Budget suggests removing food prices from the inflation target managed by the RBI. This would involve targeting core rather than headline inflation.
Basics
Inflation is the rate at which prices increase over time. Typically measured by the overall increase in prices or the cost of living, it is tracked using a basket of commonly purchased items.
| Note: A basket of goods is a collection of items used to measure inflation and changes in the cost of living over time. It’s a representative sample of goods and services that are commonly consumed by households, such as food, transportation, healthcare, medicines, housing etc. |
Headline vs. Core Inflation
- Headline Inflation: Refers to the change in value of all goods in the basket, providing a broad measure of inflation within an Economy.
- Core Inflation: It Excludes food and fuel items from headline inflation to reduce volatility. It reflects longer-term trends since food and fuel prices fluctuate significantly. In developed economies, food and fuel account for 10-15% of household consumption, whereas in developing economies like India, this figure is 30-40%. Thus, headline inflation is more relevant for developing countries.
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Inflation Targeting in India
- Inflation targeting is a monetary policy framework that involves a central bank using interest rates to steer price increases toward a publicly announced target.
- India’s inflation targeting framework, managed by the Reserve Bank of India (RBI) aims for a 4% inflation rate with a tolerance band of ±2%.
- To control inflation, the RBI employs monetary policy tools like repo rates and reverse repo rates.
- Raising the repo rate helps reduce inflation by curbing spending, while lowering it stimulates spending to boost growth.
Example of Inflation Targeting Using Repo Rate Adjustments:
- High Inflation: If inflation exceeds the target, the RBI raises the repo rate. Higher rates increase borrowing costs for banks, leading to reduced consumer and business loans. This decreased spending lowers demand and helps reduce inflation.
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The Essence of India’s Inflation Problem
The Economic Survey proposal highlights two key issues:
- Food Price and Inflation Trajectory:
- Food price inflation has been high, reaching nearly 10% year-on-year in June and remaining elevated since 2019,indicating domestic factors at work, even before the COVID-19 pandemic and the Ukraine war.
- With food being a large part of the CPI, high food prices contribute significantly to overall inflation.
- Inflation Control and Policy:
- Since 2016, the RBI has been responsible for controlling inflation through interest rate adjustments. However, it has missed the 4% target for the past five years, a challenge also faced by central banks in the UK and the US.
- The global experience shows that food price fluctuations significantly influence inflation.
Key Questions on Inflation Targeting
Two questions arise when we consider the suggestion made in the Economic Survey:
- Is the move to remove the price of food from the inflation target justifiable in terms of the goals of economic policy?
- Is the RBI likely to be any more successful in controlling core inflation than it has been in its efforts to control headline inflation?
The answer to both questions is ‘no’.
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Importance of Food Prices in Inflation Measurement
- India, being a developing country with a large poor population where a major portion of income is spent on food, has a very high share of food in household expenditure – close to 50%. This is significantly high by international standards.
- A high share of food in a household’s expenditure makes it vulnerable to a rise in food prices.
- Given this, ignoring changes in food prices by adopting an inflation target that excludes them amounts to neglecting what matters most to a very large section of the Indian population.
- A technical justification for this proposal is that food price fluctuations are ‘transitory’, meaning that increases are inevitably followed by decreases.
- However, this is not true for the Indian economy. Food price inflation has not been negative in any of the 13 years since 2011-12, the base year for the current consumer price index.
- In fact, India has a persistent food inflation problem, and the notion that food prices may be ignored because spikes are only transitory is not credible. Steps must be taken to address this issue.
Targeting Core Inflation
- This leads us to the second issue: Whether the RBI can be expected to be any more successful if it focuses solely on targeting core inflation.
- Over the past 13 years, the annual average core inflation has been within the targeted 4% in only one year, and barely so.
- A rise in the RBI’s repo rate does not necessarily dampen core inflation as claimed. In fact, increasing the repo rate may lead to a rise in the inflation rate because, as higher interest rates choke off demand, firms may raise prices to protect their profits. This is due to increased working capital costs and reduced revenues as aggregate output contracts.
Interconnection Between Food Prices and Core Inflation
- Another important point is that food price inflation is a determinant of core inflation.
- As food prices affect wages of labour in factories, which are a part of a firm’s costs along with materials.When food price inflation drives up wages, companies may raise prices of their products. This interconnection between food prices and core inflation renders the measure of core inflation without considering food prices operationally insignificant.
- Moreover, the RBI’s monetary policy, which works through changes in interest rates, cannot control inflation because the central bank has no control over food prices.
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Q. If this is widely known among discerning economists that the central bank has no control over food prices, then why does economic policy in India persist with the idea that inflation can be left to the central bank?
- This is due to an ideological shift that occurred globally after the collapse of the Soviet Union. The prevailing view became that production should be left to the market, and inflation should be controlled by the central bank. Since 1991, all political parties in India have been eager to emulate Western practices, even if they are irrelevant or damaging to the country.
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Conclusion
The rising price of food lies at the core of India’s inflation. The proposal to exclude food prices from the official measure of inflation is not a solution to the ongoing problem. The current inflation in India can only be addressed through supply-side measures that enhance agricultural yield. While the challenges are serious, they are not insurmountable for a country that overcame chronic food shortages over half a century ago. Success would require a comprehensive approach to agricultural production, one that keeps costs in check to ensure a steady supply at reasonable prices as the population and economy grow. Ignoring food inflation in the inflation target without a plan for its control would leave India vulnerable to an ever-present threat to the standard of living of its population.
August 17, 2024
