The debate over whether or not inflationary shocks on account of food should fall within the scope of monetary policy is not new. Former Reserve Bank Governor Raghuram Rajan addressed this issue in a speech in 2014, noting, “They say the real problem is food inflation, how do you expect to bring it down through the policy rate?” Rajan’s remarks highlighted the persistent challenge central banks face in balancing the need for price stability with the complexities of food-driven inflation, often beyond the immediate influence of monetary policy.
The topic resurfaced in the latest Economic Survey when the chief economist to the Centre, in the chapter ‘Medium-term outlook: A growth vision for new India’, called for re-examining the RBI’s inflation-targeting framework, suggesting food be excluded. The chief economist argued food inflation is largely driven by supply-side factors such as the unpredictability of monsoons, crop failures, and government-set minimum support prices. The RBI’s monetary policy tools, designed to combat inflationary pressures stemming from excess aggregate demand, may prove counterproductive in addressing supply-driven inflation.
However, RBI authors Michael Debabrata Patra, Joice John and Asish Thomas George, in the latest RBI Bulletin released on August 19, have countered this. They demonstrate that food inflation significantly and positively influences inflationary expectations. As inflationary expectations drift away from the central bank’s target and become “unanchored”, they undermine the effectiveness of monetary policy.
The RBI authors also find high food inflation impacts not only the magnitude of inflationary expectations, but also the duration of their persistence. Thus, even an isolated food inflation shock can sustain persistent inflationary expectations for up to two quarters. It then turns out even if food inflation lies outside the direct realm of monetary policy, it cannot be decoupled from it. Only a disinflationary monetary policy informed by food inflation trends can alleviate price pressures.
Monetary policy aims to mitigate the adverse effects of inflationary spikes by targeting headline inflation, typically measured by the Consumer Price Index (CPI). Advocates of the view that monetary policy should focus on and respond to only the non-volatile elements of the headline inflation (or core inflation) often overlook the important role that food plays. There are, of course, arguments suggesting the weight assigned to food in India’s CPI is disproportionately high at 45.86 percent, and does not align with the nation’s status as an emerging economy. This weightage of food in the overall CPI portrays India as a subsistence economy—an assumption that can be contested.
However, an examination of the average monthly per capita expenditure (MPCE) and the share of food and non-food items within it reveals that 46 percent of the MPCE for rural Indians is still attributed to food, while the corresponding share for urban Indians is 39 percent. As of June 2024, 68.8 percent of the population resides in rural areas, while 31.2 percent lives in urban areas. A simple weighted average calculation indicates that food inflation should still constitute almost 44 percent of the overall CPI, reflecting a significant portion of what is driving inflation in India.
Another issue is the anchoring of inflationary expectations so as to prevent next round increases. In this context, two points are crucial. First, households’ inflationary expectations are influenced by food prices. Second, the more credible households and firms perceive central bank policy to be, the more likely it is that inflationary expectations will remain well anchored. A central bank monetary policy that disregards food inflation will be seen as non-credible, leading to unanchored expectations. This is likely to trigger a vicious cycle of unanchored inflationary expectations, followed by higher trend inflation.
A final issue concerns the contribution of various food sub-groups to overall inflation and its implication for monetary policy. During 2016-2023, food sub-groups such as oils and fats, spices, and meat and fish contributed to higher average inflation compared to other sub-groups. Similarly, groups such as vegetables, oils and fats, and pulses, contributed to greater food volatility. These significant fluctuations can have a lasting impact on headline inflation and inflationary expectations. Hence, monetary policy would be necessary to prevent unanchored inflationary expectations.
As empirical evidence, we can examine the latest headline inflation data released by the government for July 2024, along with the inflation expectations data. The inflation data shows that while retail inflation stood at 3.54 percent—well below the 4% target—food inflation remained higher at 5.06 percent, albeit well within the psychological 6 percent limit. However, the expectations data indicates households’ median perception of current inflation rose by 20 basis points (bps) to 8.2 percent, with their inflation expectations for the three-month and one-year periods also increasing by 20 bps each. Households not only anticipate higher prices but expect the rate of price increase to be greater both three months and one year ahead. Moreover, much of these inflationary expectations were closely linked to food prices.
It is evident that controlling inflationary expectations is impossible without keeping food prices in check. The influence of food inflation on the success (or failure) of our monetary policy and economic stability is undeniable. On this, there can be no debate.
Tulsi Jayakumar
Professor, finance and economics, and Executive Director, Centre for Family Business and Entrepreneurship at Bhavan’s SPJIMR
(Views are personal)
(tulsi.jayakumar@spjimr.org)