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Photo: Mint

Data on food price rigidities can serve as inputs for RBI decisions

A new study shows variations in the price patterns of food items that could guide the framing of monetary policy in India

The government has finally appointed three new external members to the central bank’s monetary policy committee (MPC). As Ira Dugal of Bloomberg Quint pointed out soon after the official announcement on Monday, the new MPC has a good mix of talent. Ashima Goyal is a macroeconomist. J. R. Varma is an expert on financial markets. Shashanka Bhide is an economist who has done a lot of work in agricultural economics, besides macro modelling.

This array of abilities matters at a time when there are questions about whether the Reserve Bank of India (RBI) should focus more on economic growth, how to improve policy transmission through the Indian financial system, and the extent to which Indian monetary policymakers should pay attention to volatile food prices that are often dependent on weather shocks.

The Indian central bank has an official mandate to target consumer price inflation. India is unique among countries with inflation-targeting mandates because nearly half its consumer price index consists of food prices. One solution is that an updated monetary policy framework should ask RBI to target core inflation rather than the headline number.

The problem is that inflation expectations of households are very sensitive to food prices because of their importance to the average family budget. It is also easier to communicate policies on a widely understood measure such as headline inflation rather than a more technical measure such as core inflation, especially since every analyst interprets core inflation in her own unique way.

Finally, the inflation experience after the rapid recovery from the North Atlantic financial crisis shows that food inflation can quickly spread to the rest of the economy. The deeper question about whether price pressures spread from food to core, or the other way round, is an empirical one. Much depends on the stability of inflation expectations and the credibility of monetary policy.

The new MPC members should take a look at a new RBI working paper authored by G.V. Nadhanael (‘Are Food Prices Really Flexible? Evidence from India’). The RBI staff economist has put together an interesting database on food price behaviour in India, which covers weekly prices of 45 food items collected across 85 places in India for the period 2005-08. This amounts to 1.3 million data points in total. Some of the details are worth repeating here.

The price of the median food item changes 1.34 times a month, on average. However, vegetable prices change twice a month on average, while the price of milk changes only once in five months. Prices of eggs, meat and fish change on average once a month. Prices of cereals change once every three and a half months.

That is as far as broad food categories go. There is a lot of variation in the behaviour of individual food prices as well. Tomato prices change around thrice a month, groundnut oil prices once every month, mutton prices once in two months, milk prices once in over five months and biscuit prices change once in 19 months. Some of this variation reflects differences in the underlying market structure, especially the bargaining power of food producers, something that becomes important given the ongoing debates on the new farm policy introduced by the Narendra Modi government.

The upshot is that the price behaviour of the Indian food basket has a lot of variation, while most analysis lumps it together as a single item covering nearly half the target price index.

Why does this matter? Economists usually assume that food prices are flexible; they quickly move in response to changes in supply and demand. On the other hand, prices in the rest of the economy are rigid, as they take time to adjust to changes in the underlying economy. There are several reasons offered by economists for “sticky" prices outside of the food economy. For example, it may be costly for firms to keep changing the prices of their products. Or firms may have limited room to make frequent changes in prices because they are themselves tied down by long-term contracts for inputs.

Economists believe that monetary policy has no effect on real variables such as output when prices are flexible. Changes in monetary policy only affect prices. Money is neutral in this world. However, monetary policy can influence output when prices do not adjust in a flexible manner. Money here is not neutral. The implicit assumption in the view that half the Indian consumer price index is made of flexible food prices and the other half of rigid non-food prices is that monetary policy affects the two parts of the economy asymmetrically.

The new RBI working paper challenges this implicit assumption, and shows in great detail that food prices have varying degrees of flexibility or rigidity across product groups. This has profound implications for monetary policy. Most developed country central banks target inflation based on a consumer price index in which food has a weight of less than a tenth. The Indian consumer price index, in contrast, has a large exposure to food. The new MPC needs to think about feedback between food and core inflation, and the recent research on the flexibilty/rigidity of food prices can enrich the debate.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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