Inflation will continue to give RBI sleepless nights

The Reserve Bank of India (RBI) releases the ‘State of Economy Report’ every month in its bulletin. The report has become popular for its detailed analysis and outlook on the Indian economy. The State of Economy Report in the November bulletin commented that though India’s inflation declined, “we are not out of the woods yet and have miles to go”. The lines from Robert Frost’s poem has stirred commentary in the media.

Inflation has been a tricky problem for the Indian economy for quite a while now. Inflation is measured by designing indices based on consumption surveys. Consumption surveys show that households spend most of their income on food items. This is because incomes in India are still low, and low-income individuals spend primarily on food items.

Before 2012, the monetary policy used the Wholesale Price Index (WPI) for gauging inflation trends. Post-2012, the policy shifted to using the Consumer Price Index (CPI). The weight of food and fuel items is 45 per cent in WPI, and 53 per cent in CPI.

Food and fuel are highly dependent on supply factors, whereas the monetary policy impacts demand conditions. This means that nearly 50 per cent of the inflation basket responds to food and fuel shocks but does not as much to the monetary policy.

The food and fuel problem is not limited to India but applies to many countries, especially developing economies which give higher weights to food and fuel. Economists have suggested an alternative in core inflation, which excludes food and fuel from the headline index. While core inflation is a useful measure, in India and other developing economies it means that 50 per cent of the basket is excluded — which means the monetary policy is hardly inclusive. Given this, the RBI has no option but to focus on headline inflation; which means the problem remains unaddressed.

Given the struggles to lower inflation over a medium to long term, the Government of India decided to implement inflation targeting framework (ITF) from August 2016 onwards. Under the ITF, the RBI was given an inflation target of 4 per cent with a band of 2 per cent. For inflation targeting, headline CPI inflation was taken as the measure.

On analysing the inflation trends since August 2016 (graph below), we see that inflation was broadly in target for the next three years till August 2019. Thereon, inflation increases and has been at about the upper band of 6 per cent. Inflation declined during the pandemic and even recently, but has again increased.

The average inflation from August 2016 to August 2019 is 3.6 per cent, whereas the average inflation from September 2019 to September 2023 is 6.02 per cent. Food inflation was lower than 2 per cent in the first period followed by 6.5 per cent in the second period. Fuel inflation has also increased from 4.7 per cent to 6.6 per cent. It is interesting that core inflation has remained around 5-5.5 per cent during the entire period, which is also higher than the target inflation of 4 per cent. So, even though food and fuel inflation have been the main reasons for rise in headline inflation, core inflation (which excludes food and fuel) has also been above, at ~5 per cent. In the recent months, however, core inflation has declined to the 4 per cent levels.

The RBI increased its policy rates sharply to counter the rise in inflation. The repo rate has increased by 250 bps to 6.5 per cent in 10 months. Inflation did decline in the beginning of this year, but increased sharply by July-August due to a spurt in food prices.

Given the several twists and turns in inflation trajectory, the State of Economy Report mentions food inflation to be the only risk to the “RBI’s resolve to align headline inflation with the target of 4 per cent”. The central bank notes that the price of several food items is already showing an upward rise — onions, tomatoes, cereals, pulses, and sugar. The rise in food prices could once again negate the gains made in the last two months. The RBI is also expecting higher inflation in November and December.

To sum up, India’s policymakers, especially the RBI, are always weary of inflation. As one expects inflation to trend lower and remain around the target, an increase in the process of food or fuel (or both) will upset expectations. In terms of inflation, the RBI must not just bring inflation to 4 per cent but also keep it there for a long time — and that’s the challenge.

Amol Agrawal is an economist teaching at Ahmedabad University.

The views expressed above are the author's own. They do not necessarily reflect the views of DH.