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Food Inflation in Inflation Targeting of RBI
Context:
Recently in an interview Viral Acharya, former RBI deputy governor, explains the importance of including food inflation in the inflation targeting framework.
Food Inflation in India
Retail Food Inflation Trends:
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- Food inflation spiked in 2020 due to supply chain disruptions but eased in 2021 with improved supply measures.
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- CPI (45.9% weight in food) is more sensitive to food price changes than WPI (24.4% weight).
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Pandemic and Demand Impact:
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- The COVID-19 pandemic and pent-up demand initially caused inflationary pressures.
- Current inflation drivers include the Russia-Ukraine conflict, excessive heat, and uneven rainfall distribution.
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Inflation Control Measures:
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- Inflation remained manageable due to administrative measures and monetary tightening, including policy repo rate hikes after the Russia-Ukraine conflict.
- While core inflation stayed low, headline inflation remained high due to rising food prices and the El-Nino effect.
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Current Outlook on Interest Rates of RBI:
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- The Reserve Bank of India (RBI) is closely monitoring trends in food inflation. Rate adjustments may be considered if food inflation decreases.
- The RBI remains focused on maintaining its 4% inflation target while evaluating whether the current softness in economic growth is temporary or indicative of longer-term issues.
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Reasons to Include Food Inflation in Monetary Policy Targeting:
- Influence on Inflation Expectations
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- Food inflation significantly shapes household and investor inflation expectations.
- Rising food prices lead to higher wage demands, which can trigger wage inflation and affect core inflation.
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- Impact on Core Inflation
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- Ignoring food inflation can result in increased inflation expectations, driving overall inflation higher.
- Managing both core and food inflation helps stabilise expectations and maintain lower borrowing costs.
- According to Economic Survey 2023-24 while India’s Core inflation has been under control driven by RBI repo rate hike, food inflation remains high.
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- Exclusion of food inflation targeting can lead to spill over impact on core inflation leading to higher headline inflation.
- Wage Inflation and Price Generalization
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- High food inflation prompts households to expect higher future prices, pushing workers to demand wage increases.
- This can spread inflation from essentials like food and fuel to the broader economy, generalising price increases.
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- Effect on Lower-Income Households
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- Food inflation disproportionately affects lower-income households, who are more sensitive to real income changes.
- Excluding food inflation neglects these pressures, potentially worsening inflation expectations and reducing consumption, which could lead to stagflation.
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Arguments for Excluding Food Inflation from Inflation Targeting
- Volatility of Food Prices
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- Supply-Side Factors: Food prices are highly volatile due to weather conditions, agricultural productivity, and supply chain issues.
- Policy Challenges: Significant fluctuations make it difficult for monetary policy to manage inflation effectively, potentially leading to inappropriate responses.
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- Focus on Core Inflation
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- Stability and Reliability: Core inflation, excluding food and fuel, offers a more stable measure of underlying demand conditions.
- Effective Management: Targeting core inflation allows better management of aggregate demand without being swayed by temporary food price shocks.
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- Ineffectiveness of Monetary Policy on Supply-Side Issues
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- Demand vs. Supply: Monetary policy is designed to address demand-side factors, while food inflation is often driven by supply-side constraints.
- Limited Control: The RBI’s ability to influence food prices through interest rate adjustments is limited, suggesting that including food inflation may not be effective.
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- Impact on Interest Rates
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- Higher Rates: Including volatile food prices in inflation targeting can lead to higher interest rates for extended periods.
- Economic Growth: Persistent high rates due to food inflation can stifle economic growth and investment. Focusing on core inflation allows for more timely and effective monetary policy adjustments.
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