The MPC that decides the policy action has the mandate to maintain the headline CPI, also referred to as retail inflation, around 4% (+/- 2%)
While food inflation has been under check, core inflation has been above 5%
The Reserve Bank of India (RBI) reduced the repo rate by 25 basis points (bps) earlier this month, bringing it down to 6.25% from 6.50%. The Monetary Policy Committee (MPC) that decides the policy action has the mandate to maintain the headline consumer price inflation (CPI), also referred to as retail inflation, around 4% (+/- 2%). Before the policy, a majority of economists believed that RBI won’t change rates but will change its stance from “calibrated tightening" to “neutral". One of the reasons for this assumption was that “core inflation" is higher, even though CPI inflation is low.
MPC mainly takes its decisions based on retail inflation, which has remained within its targeted range in calendar 2018. The low level of inflation has largely been attributed to low food inflation. Food inflation has a strong impact on the overall headline numbers because the “food and beverages" component that covers items like cereals, vegetables, fruit and meat, among others, has 54.18% weight in the CPI basket. The overall headline CPI inflation covers all goods and services, including smaller components like food, fuel, clothing and housing.
In fact, food inflation has been negative since October 2018. Moreover, the lower-than-expected and prolonged phase of lower food inflation has led to the belief that headline inflation would continue to remain low.
Just like food inflation is a major subset of the headline CPI inflation, core inflation is a subset too. Core inflation is the inflation in components other than the volatile ones in the CPI basket. Core inflation is CPI inflation excluding food and fuel inflation. Broadly, it covers household goods, healthcare, transportation, communication, education and personal care items.
So while food inflation and headline inflation has been under check, core inflation has been above 5% since January 2018 and even crossed the 6% mark in some of the months in 2018, which is the higher end of the targeted range of MPC.
Food and fuel prices are volatile as their supply and hence prices may change in a short span of time based on factors like sudden bumper production or an unrest in some place. However, core inflation is less volatile and is in fact considered to be sticky. That is because there are no sudden changes in consumption or production patterns of things covered under this head.
Moreover, any change in interest rate or prices may not impact consumption of food and fuel immediately, but it can result in slowdown of demand of goods and services in the core basket; a higher interest rate can impact cost of production as well as consumption of these goods and services. A rate change can, hence, impact the availability of capital for the production of goods and services included in the core basket. A rate cut can make the availability of capital relatively easier and lower producers’ costs.
Experts raised concerns around core inflation before the monetary policy because it is at the higher end of MPC’s target range. Moreover, core inflation is expected to remain at those levels due to various announcements made in the budget to boost consumer spending in the form of income support schemes, interest subvention and tax exemptions.