The Economic Survey that preceded this year’s Union Budget presentation makes a suggestion which has implications for inflation control. It is that the price of food be taken out of the inflation target that the Reserve Bank of India (RBI) is mandated with. In technical jargon, this would amount to targeting ‘core’ instead of ‘headline’ inflation, which is the practice now. To appreciate fully the implication of such a move, were it to be implemented, would require recognition of two aspects. These concern the recent experience with inflation in India and the current policy for inflation control.
Food price and inflation trajectory
First, of late, food price inflation has been very high by historical standards. In June, the year-on-year increase in the price of food was close to 10%. Food price inflation has been elevated since 2019. Note that this is before the onset of the COVID-19 pandemic, not to mention the Ukraine war, implying that domestic factors are at work. With food inflation high and food accounting for a large part of the consumer price index, overall inflation has been higher than usual too.
Now to the second aspect that needs to be understood. Since 2016, by an act of Parliament, controlling inflation in India has been hived-off to the RBI, which is expected to control it through variations in the interest rate, a practice termed as ‘inflation targeting’. The term conveys a sense of both capacity and precision, that a central bank can choose the level of inflation. Actually, this is far from assured. The RBI has missed the targeted 4% every year in the past five years. In the United Kingdom, the Bank of England’s record has been patchy too. Finally, in the United States, where the Federal Reserve aims at 2% inflation, it shot up to over 8% in 2022. Since then it has plummeted to a level close to the target. In all these economies, the recent trajectory of inflation has been undergirded by fluctuations in the price of food globally.
Two questions arise when we consider the suggestion made in the Economic Survey. First, is the move to remove the price of food from the inflation target justifiable in terms of the goals of economic policy? Second, 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 the questions is ‘no’. India is an economy in which the share of food in household expenditure is close to 50%. This is very high by international standards. For instance, in the U.S., it is less than 10%.
Generally the food share is taken as a proxy for the standard of living — and, therefore, of poverty. A high share of food in a household’s expenditure leaves it vulnerable to a rise in the price of food. Given this, to ignore changes in the price of food, by adopting an inflation target which excludes it, amounts to ignoring what matters most to a very large section of the Indian population. A technical justification is given to such a proposal by asserting that food price fluctuations are ‘transitory’, that is, increases are inevitably followed by a downward movement. Well, this certainly 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, it may be said that “India has a food inflation problem”, and the assertion that food prices may be ignored as the spikes are only transitory is not credible.
Targeting core inflation
This takes us to the second issue — whether the RBI can be expected to be any more successful if it were to confine itself to targeting core inflation. This question may be answered quite easily. In the past 13 years, the annual average core inflation has been within the targeted 4% in only one year, that too barely.
This does not surprise us, for our statistical investigation yielded two reasons why this must be so. First, a rise in the RBI’s repo rate does not dampen core inflation as claimed. In fact, increasing it is seen to lead to a rise in the inflation rate. This is not without economic logic. As the higher interest rate chokes-off demand, which is how it is meant to work, firms may well raise prices to guard their profits. After all, firms face a double whammy now. Working capital costs would have increased and revenues fallen as aggregate output contracts. We found something else to be the case — that food price inflation is a determinant of core inflation, which, again, is only to be expected. After all, food prices determine wages, which are a part of a firm’s costs, the other being materials. So, wages rise as there is food price inflation.
The finding that food prices affect core inflation renders this measure of it without operational significance. It also leads to a deeper understanding. As labour enters all lines of production to a greater or lesser extent, changes in the price of food determine the inflation rate across an economy. Monetary policy working via changes in the interest rate cannot control inflation as the central bank has no control over the price of food.
If all this is so widely known among discerning economists, why does economic policy in India have to persist with the idea that inflation can be left to the central bank? This is because of an ideological shift that occurred globally after the collapse of the Soviet Union. The view that got installed was that production was to be left to the market and inflation alone was to be controlled by the central bank.
Since 1991, all political parties in India have been eager to demonstrate that they follow closely practices adopted in the West, no matter that they may be irrelevant or, worse still, damaging, to this country. Leaving food price inflation out of the inflation target is one such practice.
Focus on agricultural production
The rising price of food lies at the core of India’s inflation. The proposal to take the price of food out of the official measure of it is no solution to the ongoing inflation. For reasons explained here, if for whatever reason the price of food was to keep rising, as it has for the last five years, the RBI will not be able to control core inflation either. The current inflation in India can only be handled through supply-side measures that raise the yield in agriculture. The challenges are serious, though not insurmountable for a country that ended chronic food shortage over half a century ago. But success would require a comprehensive approach to agricultural production, one that keeps costs in check so that supply is forthcoming at a steady price as the population and economy grow.
Taking food inflation out of the inflation target without any plan for its control would leave India defenceless against an ever-present threat to the standard of living of its population. The Economic Survey suggests that the adverse welfare effect of food price inflation may be taken care of by income transfers to households. However, if food prices keep rising faster than the overall inflation rate, as they are right now, such transfers would absorb a rising share of the Budget, leaving less and less for public goods. This is undesirable. There is no alternative to controlling the rise in the prices of all goods, which currently is the avowed policy.
Pulapre Balakrishnan is Honorary Visiting Professor of the Centre for Development Studies, Thiruvananthapuram. M. Parameswaran is Professor of the Centre for Development Studies, Thiruvananthapuram
