Fighting food inflation isn’t a challenge for a single fighter

The relationship between retail and food inflation has been a matter of considerable debate, especially in light of the 2024 Economic Survey’s suggestion that food inflation should no longer be included in the inflation target, since it is largely supply driven. 

In the latest Reserve Bank of India (RBI) Bulletin released on 19 August, RBI authors Patra, John and George have countered this argument. They demonstrate that food inflation significantly and positively influences inflationary expectations.

India’s monetary policy is guided by a flexible inflation-targeting framework, under which RBI seeks to keep inflation at 4% with a permissible deviation of plus or minus 2%. 

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Based on monthly data from the ministry of statistics and programme implementation, we undertook an analysis of the relationship between the CPI-C and food inflation for the decade April 2014 to July 2024. 

We found that CPI inflation exceeded 6% in 34 of the 124 months studied (27% of the time), while in two months it was less than 2%. On the other hand, in 52 of the 124 months (42% of the time), food inflation was above 6%. 

Notably, in 20 months, food inflation was below 2%, of which seven months recorded negative inflation, while 13 months recorded positive but under 2% inflation.

These figures underscore the disproportionate impact of food prices and their volatility on overall inflation, reinforcing the argument that food prices remain a critical factor in shaping monetary policy outcomes.

A more granular analysis reveals that food inflation was actually below the CPI-C rate in 64 of the 124 months, while in one month both were the same. 

Thus, in 52.4% of the months, food inflation remained equal to or below the retail rate, with the peak negative deviation taking a value of (-)4.01 percentage points; and 59 of the 124 months had food inflation exceeding the general rate, with a peak positive deviation of 4.8 points.

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What can one make of these findings? Over the past decade, food has contributed to the overall volatility of prices. However, food inflation has not remained above the CPI-C rate continuously. 

It appears that the huge deviations between retail and food inflation (both positive and negative) may be partially explained by supply-side factors, including monsoon vagaries, crop failures and government-set minimum support prices (MSPs). 

Excess demand, especially for food sub-groups such as oils and fats, spices and meat and fish, has contributed more to high average inflation than other sub-groups.

We next juxtaposed RBI data on inflationary expectations—both median three-month ahead and median one-year ahead data—available for December 2015 to July 2024, to examine the relationship between inflation and inflationary expectations. 

Interestingly, even in the months when food inflation was negative, inflationary expectations (for both time spans) were significantly higher than actual inflation. 

For instance, in June 2017, when current inflation was 1.46% and food inflation was -1.17%, inflation expected three months ahead was 7.5% and one-year ahead was 8.6%—5.1 and 5.9 times the actual rates.

From December 2015 to July 2024, the average three-month ahead inflationary expectation has been twice the actual inflation, while the average one-year ahead expectation has been 2.2 times actual inflation.

These findings have important policy implications. Monetary policy will need to be used to reduce the impact of food-led inflation on actual inflation, the resultant inflationary expectations and the second-round effects on inflation. 

While inflation has moved away from the 2-6% target band’s upper limit set under India’s inflation-targeting framework only 27% of the time, inflationary expectations have remained ‘unanchored’ throughout this period, with expectations hovering above 7.2% and 7.9% respectively on both time-ahead scales. 

Over the span of December 2015 to July 2024, peak inflationary expectations for the three-month ahead and one-year ahead period touched 12.3% and 12.6% respectively. 

A central bank monetary policy that disregards food inflation, which so clearly drives inflationary expectations, will not be seen as credible, which could lead to those expectations getting unanchored even more. This would risk setting off a vicious cycle of high inflationary expectations followed by higher trend inflation.

Equally, the government will need to put in place a set of measures to reduce the impact of supply-side factors on food price volatility. The Centre should stop its intervention in agricultural markets through its policy of MSPs and let market forces determine food prices. 

This will reduce the distortion of production decisions. Government expenditure should instead be deployed towards raising agricultural productivity through better use of technology and irrigation. 

The government could also implement measures to reduce the gap between what farmers receive and what is paid by households by eliminating middlemen.

Also read: India's inflation targeting: Base it on reality and not perceptions

There is no either-or solution to India’s food-price problem. Only a concerted effort by the government on the supply-side and RBI through its monetary policy can tackle persistent and vexatious food inflation.

These are the author’s personal views.