Food vs core inflation: No, RBI's rate policy doesn’t need a new playbook

The Survey resurrected the spectre of core versus headline inflation, a distinction that had been largely laid to rest after the Urjit Patel committee’s recommendation of inflation targeting was accepted and the RBI Act was amended in 2016.

However, in this month’s bulletin, RBI’s researchers, led by deputy governor Michael Patra, presented a paper titled Are Food Prices Spilling Over? which argues that the persistence in food inflation has only increased due to repeated and intensifying climatic shocks and may impact non-food prices. Notably, Patra was the member secretary of the Patel committee.

The second salvo came from former chief statistician TCA Anant, who, while endorsing the Economic Survey’s suggestion, opined in Mint that the RBI’s “rigid adherence to an outdated headline inflation measure" could hinder economic recovery and growth, especially in the face of the government’s prudent fiscal strategy.

Anant also suggested that the RBI should internally re-assign weights for different consumption items in the consumer price index (CPI) to obtain a better indication of headline inflation. While his argument for updating the CPI to reflect the reduced relative share of food in the consumption basket is spot on, the fact remains that the RBI law requires the central bank to target the CPI as it is released by the government, not to construct the index independently as suggested by the former chief statistician.

And so, the RBI is going to have to wait for the government to update the relative weights in the CPI to reflect the new consumption survey results released earlier this year.

But, interestingly, the experts who make up the RBI’s monetary policy committee (MPC), including some of the non-RBI members dissenting on rate action (the MPC's decision was to leave the policy rate unchanged), have roundly discarded the idea of divesting flexible inflation target of food inflation.

The minutes from the MPC’s August meeting released last week reveal that all members unanimously fear the likelihood of continuing elevated food inflation spilling over into generalised inflation at some point and firing up inflationary expectations.

Deputy governor Patra argued the case rather eloquently: “Food price shocks may originate outside the realm of monetary policy and initially manifest themselves in supply mismatches, but when their effects stay in the inflation formation process, they can propagate through second order effects and get generalised to which monetary policy cannot be insensitive. Persistently rising prices are always and everywhere a reflection of too much demand chasing too less supply even if it is a supply shortfall that starts the price spiral. It is the remit of monetary policy to adjust demand conditions to the state of supply because this accumulation of price pressures threatens the outlook for both inflation and growth."

There is a context to the RBI’s response, part of which can be explained by a deep desire to safeguard its own credibility: The central bank consistently missed the inflation target for many months in the last five years.

RBI’s focus: A durable approach to inflation

The other immediate provocation for MPC members—who met during 6-8 August—was the inflation print. Headline inflation, as measured by CPI, has been ruling higher than the 4% target for some time now, with the June inflation data coming in at 5.1%. And though core inflation—CPI stripped of fuel and food inflation—dropped to 3.1%, food inflation remained elevated at 9.36%.

When, soon after the MPC meeting, the July CPI print came in on 12 August at 3.54%, with food inflation moderating to 5.42%, it quickly led to renewed calls for RBI to cut the benchmark repo rate.

However, it is unlikely that the RBI will drop its rates based on the data for a single month. The central bank will look for an inflation print aligned with the target on a sustainable basis.

The statement issued by RBI governor Shaktikanta Das on 8 August reveals the strategy: “Resilient and steady growth in GDP enables monetary policy to focus unambiguously on inflation. It must continue to be disinflationary and resolute in its commitment to aligning inflation to the target of 4.0% on a durable basis." The operative term here is “durable basis".

Balancing future outlook with current pressures

The RBI’s rate actions also have to be based on forward forecasts of price and growth trends, and not based solely on past data of inflation which is typically more than a month old. So, unless CPI continues to remain between 3.5% and 4% over the next few months, with a noticeable and sustainable moderation in food prices, the RBI will continue to hold its rates while focusing on withdrawal of monetary accommodation.

Commentators, including Mint SnapView, have earlier argued that the RBI’s assessment of inflation being “transitory" was misplaced. Now, when the RBI is striving to align inflation with its target in a durable manner, it should not be faulted.

This brings us to the original issue of New Delhi’s lack of comfort over the RBI’s interest rate policy. One reason could be the old bogey: Industry is reluctant to invest unless interest rates are reduced. There are no guarantees that lower interest rates will soften the private sector’s resolve to go slow on investments, given the root cause behind the reluctance, as Mint SnapView has argued earlier, seems to be the high degree of policy uncertainty in the broader economy combined with weak consumption demand growth.