Economy
Why food inflation cannot be excluded from target inflation
Summary
The Economic Survey has suggested that the inflation target should exclude food prices. The idea sounds appealing, as the volatility of food prices can defy monetary policy moves. But it’s not as simple as that, and needs a more nuanced approach.The most stringent monetary policy in decades has failed to curb food prices. In 2023-24, the Consumer Food Price Index (CFPI) surged by an average of 7.5%, and by the June quarter of 2024, it had escalated to 8.9%. The reason is simple: food prices are typically driven by supply, rendering them largely immune to monetary policy actions. This context makes the Economic Survey's recent suggestion to exclude food prices from the inflation target particularly compelling.
Historical data supports the idea that excluding food leads to a more stable inflation series. Throughout the current interest rate cycle, proposed non-food inflation—headline inflation minus the food and beverages category—was both lower and less volatile than overall headline inflation. By April 2023, non-food inflation had fallen within the Reserve Bank of India's upper tolerance band of 6%, and by September 2023, it was slightly below the 4% target. Headline inflation, on the other hand, has remained around 5% since early 2024.
But food inflation, inconvenient as it is, cannot be wished away. Food and beverages make up 45.9% of the consumer price index (CPI) basket (39.1% if we look at the CFPI). More importantly, food items punch way above their weight: food inflation was the highest contributor to total inflation over much of the post-pandemic period, and its contribution has consistently been above 50% over the past one year. With climate change intensifying the frequency of adverse weather events, crop yields are increasingly threatened, making food prices more volatile and food inflation more significant.
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Inflation expectations
Households usually build inflation expectations on the basis of recent price trends of daily-use items. Top-of-the-mind recall products include food and fuel, that’s why food inflation is a key driver of inflation expectations. When food prices are persistently high, as they have been since July 2023, inflation expectations stay high, even if fuel prices decline.
Also Read: Why we need less food in our inflation basket
The Reserve Bank of India’s (RBI) survey of inflation expectations shows that households perceive current inflation to be closer to food inflation than headline inflation. Thus an inflation measure that excludes food prices risks being lower than households’ perceived inflation.
Over time, household inflation expectations could diverge significantly from the official target. When expectations become unanchored from the target, households start making decisions based on their higher inflation estimates, thus fuelling actual inflation. This scenario is a nightmare for central banks, particularly for the RBI, which has meticulously built a reputation as a credible inflation-targeting institution.
Second-round effects
If food inflation were temporary and without spillover effects, policymakers could ignore episodes of rising food prices. However, studies show that large and persistent food price shocks significantly impact non-food prices, as observed by former RBI deputy governor Michael Patra in the central bank’s January bulletin. Within the food basket, certain items exhibit higher and more volatile inflation, which is most likely to affect non-food inflation.
This transmission occurs through two channels: the wages–price link and household expectations. When food inflation is high for a prolonged period, wages go up, ultimately leading to higher prices. At this point, inflation becomes generalized, rather than being restricted to food. Unanchored inflation expectations also push up future inflation. All central banks, including RBI, aim to prevent these second-round effects of food inflation because it makes monetary policy ineffective in targeting inflation.
Flexibility is better
The primary argument for excluding food prices from the inflation target is that it is outside the ambit of monetary policy. But research from the RBI shows that while 90% of food inflation is, indeed, caused by supply-side factors such as poor weather, supply disturbances and international price fluctuations, 10% is attributed to demand-side factors, too.
Thus, the paradox of food inflation emerges: it is transitory but can become generalized; it is supply-driven but has a minor cyclical component; it is not part of core inflation yet drives household expectations. It cannot be ignored nor given central importance in monetary policy. The solution lies in a flexible, situation-driven approach to inflation targeting, as practiced by the RBI. This flexibility allowed the RBI to overlook rising food prices when growth was a priority (2020, 2021) and ensures vigilance over food prices even when headline inflation trends downward.
The author is an independent writer in economics and finance.
