Reassessing Inflation Measurement

Source: The post reassessing inflation measurement has been created, based on the article “India’s inflation aim: Let us go by its reality and not the perception” published in “Live Mints” on 22nd August 2024

UPSC Syllabus Topic: GS Paper 3-Indian Economy-Inflation

Context: The article discusses the debate on whether India’s inflation targeting should focus on non-food inflation, given that monetary policy better controls demand-driven inflation, while food inflation is supply-driven. It suggests reconsidering how inflation is measured and targeted.

For detailed information on Inflation Targeting in India read this article here

What Does Recent Data Show on Inflation?

1. Recent data indicates that food inflation has remained consistently high, exceeding 6% in both urban and rural areas since July 2023.
2. In contrast, non-food inflation has steadily decreased and is now below 2%.
3. Despite the decline in non-food inflation, overall headline inflation remains above the 4% target due to the persistent rise in food prices.
4. The Household Consumption Expenditure Survey (HCES) reveals a decline in the share of food in total household expenditure since 2011-12—from 36.4% to 34% in urban areas and from 54.2% to 45.7% in rural areas.
5. This decline suggests that the Consumer Price Index (CPI) may be overestimating inflation, as the weighting for food might be outdated.

What Is the Debate on Inflation Targeting?

1. Focus on Non-Food Inflation: The Chief Economic Advisor suggests focusing inflation targeting on non-food inflation, as monetary policy effectively controls demand-driven inflation, unlike supply-driven food inflation.
2. Importance of Food Inflation: The RBI Governor argues that food inflation significantly shapes public inflation expectations, as people primarily perceive inflation through food prices. Persistently high food inflation has kept headline inflation above 4% since July 2023.

How Does Monetary Policy, Combined with Fiscal Strategy, Impact Domestic Manufacturing and Economic Recovery?

1. Monetary Policy and Manufacturing Costs: Restrictive monetary policy increases the operational costs for domestic manufacturers. This makes them less competitive compared to global manufacturers, as their products become more expensive to produce. This can negatively impact the balance of trade, leading to increased tariffs, higher prices, and slowed economic growth.
2. Government Response to Trade Imbalances: If the government responds to trade imbalances by raising tariffs, it could lead to higher domestic prices and slower growth. This information is correctly reflected in the point.
3. Economic Recovery: The article suggests that monetary policy should be aligned with a more accurate inflation measure, especially when the government is following a prudent fiscal strategy, to support economic recovery. This is consistent with the content provided.

Why Is Reassessing Inflation Measurement Important?

1. Outdated Weighting: The Consumer Price Index (CPI) uses a weighting basket from 2011-12. Household Consumption Expenditure Survey (HCES) shows food’s share in household expenditure has dropped (urban: 36.4% to 34%; rural: 54.2% to 45.7%), suggesting the CPI may overestimate ‘real’ inflation.
2. Different Impact Across Income Groups: The poorest 5% of urban households spend 44% of their income on food, compared to 27% for the richest 5%. This creates significant disparities in experienced inflation.
3. Monetary Policy Effectiveness: Monetary policy is more effective in managing demand-driven inflation, not supply-side food inflation. Focusing on outdated CPI measures could misalign policy with economic realities, potentially hindering economic recovery and growth.
4. Perception vs. Reality: Public perception often overestimates actual inflation, influenced by short-term changes in food prices, leading to potentially misguided policy decisions.

What Should the Monetary Policy Committee Consider?

1. The Monetary Policy Committee should consider re-weighting the CPI using the latest HCES data to better reflect current spending patterns.
2. It should also recognize that monetary policy is less effective in controlling supply-side food inflation.
3. The inflation targeting framework may need to be updated to align better with actual economic conditions rather than public perceptions.

Question for practice:

Evaluate the effectiveness of focusing India’s inflation targeting on non-food inflation given the persistent rise in food prices and its impact on headline inflation.