Holistic inflation assessment must for right rate call

Does the central bank of Asia’s third-largest economy deserve to hold-up its monetary policy decision, that largely impacts investments, because vegetable price rise that occurs mostly due to supply shocks, is lifting up headline inflation numbers?

The Reserve Bank of India’s decision last week, based primarily on skyrocketing onion prices, has not only stirred mixed reactions among economists but is also pushing the government to hasten the revamp of consumer price index formula, lowering the weight given to food/vegetable in the inflation basket, to have a more stable inflation print. Excluding vegetables, the headline retail inflation print stands at 3.49% as against 5.54% in November.

At 45.3%, food accounts for the highest weight in India’s consumer price inflation basket that the RBI tracks for inflation targeting. Nowhere in the world, food and vegetables acquire such huge weight in the inflation index. In China, whose investment-led growth has become a new policy prescription for the Modi government, food accounts for around 27%, Brazil, 26%; Africa, nearly 20%; and the USA, a little above 15%.

Higher food weight in inflation basket means even a moderate spike in food prices can cause a bigger rise in CPI inflation. Lowering the weight of food on CPI is required not only to reflect the true consumption pattern but also to save the index from frequent fluctuation. Generally, in low-income countries, food accounts for a large proportion of consumer spending and therefore carries a large weight in the inflation basket. As incomes start rising, the share of household expenditure on food begins to fall. That demands a readjustment in the inflation basket to reflect the new consumption pattern.

In India, however, the revision of weight in CPI basket was done in 2015, when the base year was also changed from 2010 to 2012. India’s per capita GDP has increased from $1,639 in 2015 to $2,171 in 2019. When China’s National Bureau of Statistics revised its CPI basket recently, it added new products and services such as financial services and medical care, which saw an increase in spending.

The retail inflation index is prepared from the prices of goods and services collected from over 1,000 markets in over 1,500 towns and villages. Economists say the number needs to be revised upwards and new goods and services need to be added to strike a balance between food and manufactured goods. Core inflation, which strikes off food and fuel, and adds services component into its ambit, needs to be strengthened further.

The new consumption expenditure survey, which has been withheld by the government due to data quality issues, is being made more robust to reflect the true consumption pattern and the CPI index will be revised based on that, according to a government official. Overweight of food in the basket not only restrains RBI from making a correct prognosis of inflation in the medium to long term but also leads to wrong assessment of inflationary expectations by households. It also leaves economists confused in making projections.

Food prices are more volatile in India as it depends on several factors including the vagaries of the monsoon.

If the index is heavily tilted towards food, it can swing inflation numbers either way, without reflecting the broad price situation.

That probably was the reason RBI governor Shaktikanta Das, after maintaining a status quo on policy repo rate in early December monetary policy review, submitted that he needed more time to have more clarity on the central bank’s projection on inflation, though all other indicators pointed to the price rise moderating below the RBI target of 4% by the next two to three quarters.

Stagflation worries

A 10% spike in food prices, although for the first time in the Modi regime, led to a greater spike in the headline number and worsened households’ inflation expectations increasing it by 120 basis points over the 3-month ahead horizon and 180 basis points over the 1-year ahead horizon. It also led to a few economists flagging stagflation worries.

Obviously, stagflation is the most difficult problem that the policymakers have to face. It combines a situation where inflation is stubbornly high with falling economic growth and a substantial rise in unemployment.

It is a situation in which, if the government increases spending and central bank lowers interest rates, it can lead to a rise in demand for goods, jacking up their prices. This leads to a rise in wages but ensures that a lid cannot be kept on inflation, which can leave more people jobless.

Conversely, if the central bank compresses money supply and raises interest rates, it can end up in choking investment. But is India really facing stagflation right now? Can the volatile food prices determine actual rise or fall in prices of a host of other goods and lead the central bank to formulate monetary policy based on that?

A look at the core inflation, which is the more stable variant and focuses on the general increase in price levels over the long-term, suggests that it is actually falling or making an insignificant move upwards. This is indicative of the diminishing pricing power of producers. It points to a deflationary situation, where the general price level of goods and services go down, and not stagflation.

The RBI’s mandate allows it to target only the headline inflation and therefore, the government must do everything within its reach not to distort the headline.

Along with rejig in CPI inflation basket, that the government is planning to undertake soon, it should also allow RBI to look into inflation in a holistic way. The global financial crisis of 2008 has turned the spotlight of central banks around the world towards growth concerns but not at the cost of higher inflation.