Room for rate adjustments if food inflation decreases: Viral Acharya

Acharya explains why food inflation should not be excluded from the inflation targeting framework

Viral Acharya, former deputy governor of the Reserve Bank of India (RBI) and CV Starr Professor of Economics, Department of Finance, New York University Stern School of Business, explains why food inflation should not be excluded from the inflation targeting framework in an interview with Anjali Kumari. Edited excerpts:

Should monetary policy target inflation without taking food prices into account?

Food inflation influences both household and investor expectations of inflation. When these expectations remain stable, inflation uncertainty and term premiums stay low, which helps reduce borrowing costs across the economy — not just for governments, but also for banks and corporates.

Research consistently shows that when households perceive high food (and fuel) inflation, their inflation expectations rise. If workers see rising costs in essentials like food and fuel, they tend to demand higher wages, leading to wage inflation. This, in turn, causes food and fuel prices to affect core inflation, leading to a broader generalisation of inflation. The idea that different components of inflation are independent and unaffected by each other is inaccurate.

Controlling core inflation over time helps align headline inflation with it, especially when food and fuel inflation is driven by supply shocks. Ignoring a large portion of inflation, such as food, when it is structurally high, can lead to rising inflation expectations, even if core inflation remains low. Therefore, central banks need to manage core inflation to control overall inflation expectations and cannot simply disregard food inflation.

There is another reason why food inflation is important to consider. Inflation targeting is often adopted by governments as part of a political agreement, delegating inflation control to central banks in the broader interest of citizens. For instance, the 4 per cent inflation target in countries like India (or 2 per cent in others with fewer supply shocks) is partially set to protect lower-income segments of society, whose purchasing power is most eroded by high inflation. These households are particularly sensitive to changes in real income, as they have a high marginal propensity to consume. In contrast, wealthier individuals, who are more invested in financial assets, may benefit from higher inflation due to reduced real debt levels and increased nominal cash flows. As a result, governments and central banks typically target inflation levels that benefit the median population rather than just the wealthier, financially-invested sectors of the economy.

Some argue that food inflation should be excluded from inflation targeting, suggesting that interest rate policies should primarily serve the urban population, hoping for trickle-down economics to take hold. However, this approach overlooks the inflationary pressures faced by other segments of society, which can compound through inflation expectations and reduced consumption, potentially creating stagflationary headwinds.

What is your current outlook on interest rates, both globally and domestically?

The market expects three to four rate cuts in the US over the next year, which seems reasonable given the mixed signals on growth from the US economy. In India, the RBI is closely monitoring food inflation, as specified in its recent announcements.

If food inflation decreases, there may be some room for rate adjustments. Currently, the RBI seems squarely focused on maintaining headline inflation at its target level of 4 per cent.

The RBI is determining whether the current softness in growth is temporary or could be prolonged due to factors such as fiscal consolidation or the need for upgrades. In the short run, there could be growth weaknesses, which the RBI may consider in its rate decisions.

The RBI has flagged concerns about the widening gap between credit and deposit growth. Do you see any risks there?

The discussion around the credit-to-deposit ratio and liquidity indicates that, despite high interest rates, there is strong credit demand growth. The RBI may therefore be cautious about fuelling further credit growth, particularly in unsecured retail borrowing.

Recent measures taken by the RBI, such as increasing risk weights on bank lending to non-banking financial companies and removing certain bonds from indices due to liquidity concerns, also reflect a prudent approach to ensuring financial stability.

As for foreign portfolio inflows following India’s inclusion in JP Morgan’s bond index, it may take another year or two to fully realise the impact.

Sovereign green bonds auctioned this year received a lukewarm response. How do you see demand for them evolving in the future?

Regarding sovereign green bonds, the government may prefer to concentrate its borrowing on benchmark securities to maintain a stable yield curve, leaving the corporate sector to handle green bond issuance. In my view, the focus should be on maintaining a stable yield curve and making bonds attractive to index fund investors.