India’s central bank should adhere to its inflation-targeting mandate

Less than four years after the government concluded its review of India’s inflation-targeting regime in April 2021 and opted to keep both its target and nitty-gritty—its target range, indicator, etc—unchanged, its view of inflation targeting seems to be shifting.

After commerce and industry minister Piyush Goyal and then finance minister Nirmala Sitharaman called for lower interest rates, on Tuesday chief economic advisor (CEA) V. Anantha Nageswaran questioned the use of headline retail inflation as India’s yardstick to guide monetary policy.

Also read: Food inflation: Blame supply shortfalls as well as bad policy interventions

If Goyal flayed the Reserve Bank of India’s (RBI) rate policy, saying it was a “flawed theory” that food inflation should be considered while framing it, the FM was just as forceful, calling for bank interest rates to be “far more affordable” and adding that several people found the cost of borrowing “very stressful.”

In contrast, the CEA stopped short of calling for a cut in interest rates. Speaking at a State Bank of India conclave, he pointed out that if the prices of just a few items are excluded—notably, TOP (tomatoes, onion and potatoes), gold and silver—then inflation falls to 4.2% (close to the mid-point of RBI’s target range of 2-6%), as against the October number of 6.2%.

The implication was clear: Monetary policy guided by a CPI shorn of TOP, gold and silver will allow for a reduction in interest rates. This is apiece with the position he championed in the latest Economic Survey, which called for targeting core inflation instead of headline.

Similar arguments have been heard before; they tend to arise when food and non-food inflation trends diverge. India’s inflation-targeting regime and related amendment to the RBI Act, however, mandates the use of headline Consumer Price Index (CPI) inflation. Importantly, the latest review found nothing objectionable in this choice of indicator.

Also read: Why food inflation cannot be excluded from target inflation

The minutiae of how the CPI is computed, its composition, weights and so on might excite a tiny section of the cognoscenti and impact policy formulation, but, as the recent US election shows, what matters to the person on the street is how high prices have gone, not their exact rate of change over the past year.

For guardians of price-stability to be responsive to popular pain, they must keep a lid on headline inflation, not on some esoteric construct with arbitrary exclusions.

True, monetary policy has a limited direct impact on food prices, especially when supply constraints push them up, since demand for food is highly inelastic. But that is no reason for our inflation gauge, the CPI, to be tweaked. Moreover, there are important second-order or spillover effects. RBI Governor Shaktikanta Das put it well.

The high share of food in the consumption basket, he said, meant food inflation pressures cannot be ignored. Stating that the public at large understands inflation more in terms of food inflation than the other components of headline inflation, he elaborated, “Therefore, we cannot and should not become complacent merely because core inflation—stripping out food and fuel—has fallen considerably.”

The Monetary Policy Committee (MPC), he went on to add, “may look through high food inflation if it is transitory; but in an environment of persisting high food inflation, as we are experiencing now, the MPC cannot afford to do so.”

Also read: In charts: Volatile vegetables are making inflation bitter

The rate-setting panel “has to remain vigilant to prevent spillovers or second round effects from persistent food inflation and preserve the gains made so far in monetary policy credibility,” Das had said. Rightly so.