After the presentation of the Union Budget later this week, focus will soon shift to the Monetary Policy Committee
(MPC) of the Reserve Bank of India (RBI). While the course of the monetary policy will be influenced by the Budget, market participants would be keen to see how the rate-setting committee deals with the inflation surprise. Inflation, based on the consumer price index
(CPI), rose sharply to 7.35 per cent in December, exceeding the central bank’s upper end of the target band. Analysts expect retail inflation
to remain elevated for some time, partly because of the telecom tariff hike.
However, retail inflation
is being driven largely by food prices, particularly those of vegetables, and core inflation is within the comfort zone. Thus, it is being argued by economists and industry representatives that the MPC should ignore headline inflation, driven largely by vegetable prices, which is seasonal, and focus on core inflation. It is also being reasoned that the CPI, which gives over a 45 per cent weighting to food and beverages, is itself outdated and does not reflect the actual consumption basket of Indian households. A lower weighting to food items in the index will make it representative of the new realities, less volatile, and more useful for monetary policy.
While some of the arguments are well-founded, it is worth examining what the central bank can do. For instance, the MPC has noted that higher inflation is not limited to vegetable prices and is spread across food items, such as milk, pulses, and cereals. Households’ inflation expectations, according to the RBI’s November survey, went up by 120 and 180 basis points for a three-month and one-year horizon, respectively. Since expectations, which are currently being driven by food prices, significantly affect outcomes, it will be difficult for the MPC to ignore food inflation. Further, the Indian central bank is mandated by law to target headline inflation, not core inflation. The expert committee constituted to revise and strengthen the monetary policy framework under Urjit Patel deliberated carefully and recommended in favour of targeting the headline CPI. It noted that the “… exclusion of food and energy may not yield ‘true’ measure of inflation for conducting monetary policy”. It also said that an improvement in the CPI will help make it a more robust measure of inflation conditions.
It is possible that the consumption pattern of households has changed since the consumer expenditure survey of 2011-12 and Indian households are now spending more on health and education. But the government has decided to junk the last consumer expenditure survey, so the revision would have to wait till the next survey. The committee set up by the government under former chief statistician Pronab Sen to review economic statistics could also be asked to suggest ways to improve the CPI. But theoretically, even if the MPC were to target core inflation, it would not open up much space for monetary easing. Core inflation was above 4 per cent till September 2019. Besides, the bigger issue at the moment is the transmission of policy rates to bank lending rates, which depends on a variety of factors, including the fiscal situation. While there is a case for updating the CPI, it is also important to recognise the limitations of monetary policy to support growth in the given macroeconomic environment.