Inflation targeting without food is no solution

While the interests of famers need to be protected, it would further complicate monetary and macroeconomic management

The Economic Survey (ES) of 2023-24, released recently, has suggested exploring whether India’s inflation targeting framework should focus on the inflation rate excluding food, as farmers are prevented from benefitting from rising prices. It argues that short-term monetary tools to address inflation caused by supply constraints may be counterproductive. This suggestion raises some crucial issues.

First, it is true that monetary policy is a tool for demand management and it has no influence on an increase in food inflation. However, monetary policy has a critical role in reining in the “second-round effects” of high and persistent food inflation.  If a supply shock is transitory, then it is not a major concern and monetary policy can look through it because the elevated inflation (due to a supply shock) will fall back to the initial level once the shock abates. Also, monetary policy operates with long and variable lags (typically more than a year). Therefore, before its impact is felt, inflation could drop to its initial level.  However, if a supply shock persists, there is a risk of high food inflation spilling over to headline inflation through the wage-price spiral, as the public begins to incorporate higher food inflation into their expectations. This risk of “second-round effects” increases if high food inflation persists for an extended period.

India often faces supply shocks for one food item or another. Also, food inflation in India has a disproportionate impact on inflation expectations of households because it is experienced on a day-to-day basis, unlike headline inflation. Therefore, in India, the risk of second-round effects  is high.  There have been several instances in the recent past when high and persistent food inflation spilled over to headline inflation. The risk of second-round effects will remain whether food is included in the inflation measure targeted by the Reserve Bank of India (RBI) or not.

Second, excluding food from consumer price index (CPI), which has a weight of 45.8 per cent, may dent the credibility of the RBI as the monetary authority.  The headline measure of inflation broadly captures the cost of living of a basket of goods and services consumed by a typical household in daily life. Any measure of inflation that excludes almost half the consumption basket cannot serve as a basis for the overall cost of living. Households also pay for food and it will be hard to explain to the general public why the RBI cares only about half of their consumption basket. Though vulnerable sections of society could be protected, as indicated in the ES, by direct benefit transfers, it would still expose a large section of society to high food and headline inflation. Excluding food items from the target measure may lead the general public to perceive that the RBI is diluting its commitment to price stability.

Third, targeting the CPI excluding food can pose a significant communication challenge for the RBI, especially if the headline inflation rate and the inflation rate excluding food diverge significantly, as has often happened in India.  In fact, the sharp divergence between the headline inflation and the core measure of inflation (which normally excludes volatile items such as food and fuel from headline measure of inflation) was precisely the reason why the Bank of Thailand (BoT) abandoned the targeting of core measure in 2005 in favour of the headline measure. The core inflation measure targeted by BoT increasingly lost its ability to reflect the real cost of living when headline and core inflation diverged considerably. The Bank of Korea is another central bank that replaced the core measure of inflation as the target, with the headline measure of inflation in 2007.

All major central banks that have adopted the inflation targeting framework, target a headline measure of inflation, which is simple to understand and easy to communicate. However, to avoid any missteps while framing monetary policy, almost all central banks, including the RBI, use some form of core measure of inflation to serve as a short-term operational guide to achieve their objective of controlling overall inflation. Such measures of inflation are used to gauge the underlying rate of inflation (the rate of price change that could be expected to prevail under normal circumstances in the absence of any supply shock). 

Fourth, once food items are excluded from the headline measure of inflation, whatever be its justification, it would open the doors for subjective judgements creeping into the selection of goods and services covered in the index targeted by the RBI.

An appropriate way to deal with the issue is to provide the RBI with greater manoeuvrability in conducting monetary policy by revising the weights of CPI to reflect the changing realities. In the Household Consumption Expenditure Survey (HCES) for 2022-23, released in March 2024, the share of food in average monthly per capita consumption expenditure declined significantly, both in rural India (from 57.0 per cent in 2009-10 to 47.5 per cent in 2022-23) and urban India (from 44.4 per cent in 2009-10 to 39.2 per cent in 2022-23). Therefore, there is an urgent need to revise the weights of the CPI basket.  As the Indian economy continues to grow and income levels rise, the relative weight of food in households’ consumption baskets should decline further.  Therefore, it should be the endeavour of the government to adjust the weights of CPI once every three years. 

While the interests of farmers need to be protected, there is a need to find a better alternative. Targeting inflation excluding food will only complicate monetary and macroeconomic management.

The writer is senior fellow, Centre for Social and Economic Progress, New Delhi, and a  former executive director of RBI and member of the Monetary Policy Committee