In its sixth bi-monthly monetary policy statement, the Reserve Bank of India (RBI) kept the repo rate unchanged at 6.25%. Surprisingly, the monetary policy stance has been shifted from accommodative to neutral. The most prominent reason to shift the policy stance is the objective of achieving 5% inflation by quarter 4 of 2016-17 and the medium term target of 4% with a band +/- 2% on either side. Even though the headline CPI (consumer price index) inflation is moderating, the monetary policy committee (MPC) cited concerns about sticky core CPI inflation. It is therefore essential to analyse the role of headline against core inflation in fixing the policy stance.
In the RBI’s newly adopted flexible inflation-targeting (FIT) framework, the headline CPI inflation measure is being used as the target rate of inflation as it reflects the prices of essential consumption goods. Inflation in these prices hurts people in lower-income groups more as they spend a higher proportion of their incomes on these items. Since the objective of monetary policy is to maintain price stability so as to protect ordinary citizens from the bouts of inflation, targeting headline inflation is the appropriate choice. However, in recent monetary policy statements, it is felt that the focus of monetary policy has been more on core inflation than headline inflation.
The headline inflation measure demonstrates overall inflation in the economy. Conversely, the core inflation measure strips the prices of highly volatile food and fuel components to distinguish the inflation signal from transitory noise. The inflation process in India is dominated to a great extent by supply shocks. The supply shocks (e.g., rainfall, oil price shocks, etc.) are transitory in nature and hence produce only temporary movements in relative prices. The headline CPI inflation in India tends to increase whenever there is a surge in food and fuel prices. Since monetary policy is a tool to manage aggregate demand pressures, the response of the policy to such temporary shocks is least warranted according to traditional wisdom.
This is because the monetary policy affects output and inflation with a lag. Hence, the impact of monetary policy action today in response to a supply shock would materialize only some quarters later, when the temporary shock to prices would already have been reversed. However, in such a scenario, if the temporary supply shocks produce strong second-round effects, the policy response is warranted.
Conversely, core inflation excludes the highly volatile food and fuel components and therefore represents the underlying trend inflation. The trend inflation drives the future path of overall inflation. Hence, even when food and fuel inflation moderates over time, persistently high inflation in non-food, non-fuel components poses an upward risk to overall future inflation, creating challenges to monetary policy.
The RBI faced a similar challenge in fixing the policy stance recently. Headline inflation in India slowed to 3.17% in January 2017 on the back of a sharp fall in food prices such as those of vegetables and pulses. Conversely, core inflation remained sticky around 5% due to inflation in the services component, mainly transport and telecommunication.
Why is core inflation so important in deciding policy stance? Since it represents the underlying inflation trend, high core inflation today carries the seeds of high future inflation. Also, as long as temporary supply shocks fail to bring about changes in the underlying trend (core) inflation, headline inflation will revert to core inflation. This is the desirable outcome from the policy perspective.
However, shocks to headline inflation such as food and fuel price shocks, if they persist for a longer period of time, would feed into the higher long-term inflation expectations of people, generating substantial second-round effects. When this occurs, core inflation would revert to headline inflation, posing challenges to monetary policy. We cannot deny the presence of strong second-round effects of supply shocks pushing up core CPI inflation in India.
The critical role of monetary policy, then, is to block the second-round effects of supply shocks by anchoring long-term inflation expectations. However, the task of anchoring inflation expectations depends on the credibility of the central bank, established through its commitment towards medium- to long-run inflation targets. With high credibility and well-anchored inflation expectations, low and stable inflation can be achieved even when the headline inflation increases due to relative price changes.
In the FIT framework, the RBI has provided CPI inflation as a nominal anchor to monetary policy. Effectively, household inflation expectations in India seem to have come down gradually. The recent 46th round of inflation expectation survey of households by the RBI in December 2016 indicates a sharp fall in the three months and one year ahead median inflation expectations of households to 7.3% and 8.3%, respectively.
To sum up, price stability implies control of overall inflation. The medium- to long-term goal of monetary policy, therefore, should be to control headline inflation. However, core inflation is the means to achieve low and stable inflation and hence cannot be ignored completely. That is why the RBI is really trying to look beyond headline inflation.
Bhavesh Salunkhe and Anuradha Patnaik are, respectively, research student and assistant professor at the department of economics (autonomous), University of Mumbai.
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