Inflation Management in India- Challenges and Way Forward- Explained Pointwise

The economic survey 2023-24 has suggested changes in India’s Inflation management approach. The economic survey has proposed removal of food prices from India’s inflation target. It suggests shifting of inflation targeting in India from the ‘headline‘ to ‘core‘ inflation. However, there are concerns whether the exclusion of food items, will yield the desired results.

In this article we will delve into inflation, its targeting method currently employed. We will look at the concerns being raised about the shift in approach of inflation targeting from ‘headline’ to ‘core’ inflation. We will look at the other challenges in inflation management in India.

What is inflation? What is the inflation targeting method followed in India?

Inflation- Inflation refers to the rise in the prices of most goods and services of daily or common use such as food, clothing, housing, recreation, transport, consumer goods. Inflation measures the average price change in a basket of commodities and services over a period of time.

Different Inflation indices used in India

WPI Inflation- WPI captures the average movement of wholesale prices of goods only. Its major components are- Manufactured goods (64.23%) > Primary articles (22.62%)> Fuel and Power (13.15%). It is primarily used for ascertaining GDP Deflator in the economy.

CPI Inflation- CPI captures the movement in prices of goods and services that are acquired by the households for consumption purposes. Its major components are- Food and Beverages (45.86%) >Housing (10.07%)> Transport and communication (8.59%)> Fuel and Light (6.84%). It is primarily used for RBI’s Inflation targeting and measurement of DA for employees.

Headline and Core Inflation

Headline Inflation- Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices, which tend to be much more volatile and prone to inflationary spikes. The headline inflation is reported through the Consumer Price Index (CPI) in India.

Core Inflation- Core inflation is the persistent component of inflation in India. It attempts to remove the volatile, transitory movements from the CPI. In India, it is measured by removing Food and Fuel categories from CPI.

Present Inflation Targeting Framework in India

The Reserve Bank of India is the authority to control inflation under RBI Act 1934. Presently, the RBI targets headline CPI inflation as part of its ‘inflation targeting’ mandate.

Economic survey has recommended shifting from ‘headline’ to ‘core inflation’ by removing the food component. The economic survey contends that the food price fluctuations are ‘transitory’ in nature. That means that it’s increase is inevitably followed by a downward movement.

What are the concerns regarding Economic survey’s recommendation for inflation management?

1. Neglect of economic reality- In India, food accounts for nearly 50% of Indian household expenditure. It is crucial to most people’s cost of living. Ignoring food prices in inflation targeting would lead to neglect of a major economic concern for a large portion of the population.

2. Transitory Fluctuations of food prices is a misconception in India- Contrary to claims that food price fluctuations are temporary, food inflation in India has been persistent for over a decade. This indicates a structural problem, and removal of food inflation from inflation targeting will not solve the problem.

3. Interdependence of Food and Core Inflation- Food prices influence wages, which in turn impact core inflation. Hence, it would be difficult to control core inflation independently of food prices.

4. Misguided Policy- Exclusion of food prices from the inflation target could leave India vulnerable to rising food costs. This would undermine the standard of living for a large segment of the population.

5. Ineffectiveness of Interest Rate Adjustments- Raising interest rates have not led to curbing of core inflation but has instead exacerbated it by increasing the costs for firms. This has led to higher prices of the products and higher inflation in the economy.

What are the other challenges in Inflation management in India?

1. Monetary Policy singular focus on demand side- RBI’s monetary policy targets only demand side constraints. It faces the problem of tackling supply shocks originating from food and oil.

2. Flawed Model of Inflation targeting- Monetary Policy model used for Inflation management in India is not statistically validated for Indian data. The current model of Inflation targeting is based on the assumption that inflation means overheating the economy– that is increased output greater than natural level output. However, In India it is impossible to observe the actual level of output in an economy. Hence, setting policy rates based on the assumption that the economy has overheated is unscientific.

3. Failure in addressing supply shocks- Adoption of a myopic vision in inflation management by focussing on export ban of agricultural products (like wheat, rice, onions), leads to increased inflation. Export bans induce fear and panic in the domestic market, leading to rise in stock holdings, which ultimately result in price rise.

4. Exclusive Focus on Inflation slows down growth- RBI’s current mandate of inflation management is too singularly focused on controlling inflation. Inflation management has negatively impacted GDP growth. High policy rates (repo) maintained to control inflation affected the cost of domestic capital. It led to a decline in investment rate, thereby resulted in less GDP. For ex- Since 2016 (after inflation rate targeting was institutionalised), there has been a steady increase in repo rates, and a steady decline in GDP growth.

5. Ignoring the Global Nature of inflation- Inflation is global in nature, as the price level of a good is determined by millions of producers across the world. Hence, solely targeting inflation management is not good for the health of the economy, as certain prices of goods are beyond our control.

What should be the Way Forward?

1. Increasing agricultural production- We must focus on improving agricultural productivity and controlling food prices through supply-side measures to address inflation in India.

2. Release Excess Buffer Stocks- The government holds more than 40 million tonnes of rice, much above the buffer stock norms of 13.5 MT. This excess stock should be unloaded by Food Corporation of India in the open market at reasonable prices. This will cool down the food inflation.

3. Enhancement of Processing Capacity- About 10-15 percent of perishable items like tomatoes and onions should be processed. The availability of alternatives like tomato paste and onion powder will help to stabilize prices.

4. Adjustment of Import Duties- Import duties on items like wheat should be reduced, as cheaper imports can help control domestic prices.

5. Updation of the CPI Basket Weights- The weight of food and beverages in the CPI basket should be adjusted to reflect current realities as the weights are based on the 2011 consumption survey.

6. Greater Tolerance of Higher levels of Inflation- Since Inflation is a global issue, there must be greater tolerance for higher levels of inflation either by adjusting the acceptable range of inflation upwards, or by extending the period over which the MPC has to meet its inflation target.