India was following the herd of central banks that had joined the ranks of inflation targeters, a trend that started in the 1990s. In this policy framework, called flexible inflation targeting, RBI had a mandate and a numerical target of an inflation band given by the government.
This was formalized as a contract between RBI and the government, with the former to be held accountable in case of deviation. RBI also had an implicit dual mandate: high growth had to be sustained too, but price stability had primacy. This was reiterated in a 2021 review of this framework.
But lately, there have been noises on two fronts. Does an exclusive mandate of inflation targeting make sense? And should not the numerical target of inflation exclude food and fuel items since their prices are volatile and beyond the control of RBI actions?
This column will not dwell much on the first issue of whether exclusive inflation targeting should be jettisoned. Since the early days of central banking, protecting the value of the currency—or ensuring price stability—has been the prime focus.
Multiple mandates of also ensuring high growth and employment, or fast credit growth, a stable exchange rate and lately overall financial stability are all add-ons, and not all central banks sign on to these. There can be separate regulatory arrangements for each of these additional objectives.
Even the central bank has separate departments to focus on exchange rate stability or financial markets. Also, on the dual mandate issue, it has been established that in the medium to long term, there is no trade-off between low/stable inflation and high growth. Indeed, the former enhances the chances of the latter.
In the short run, tolerating higher inflation for pumping higher growth is a Keynesian idea on which there is a fading consensus. That is because once you take into account the role of people’s expectations about future inflation, or the impact of short-term growth induced by policy or inflationary financing of government spending, the reward of higher growth is muted.
Private investment is not enthused by inflationary policy action aimed at such short-term pumping.
On the second issue of whether to exclude food and fuel from the target inflation gauge, there is a more nuanced debate. In developed countries, these volatile components account for a small portion of overall consumer spending. That is because of their high per capita incomes.
In India, it is only recently that the average consumption basket’s share of spending on food and fuel fell below 50%. When the mandate is to ensure overall price stability, how can you exclude almost half the basket? Food inflation tends to spike due to supply shocks like climatic events or oil price movements.
Since food demand is relatively inelastic and supply cannot increase overnight, prices shoot up. But with low per capita incomes, the food budget affects overall spending. And food price inflation could put pressure on wages, causing an inflationary spiral.
Monetary policy cannot ignore such movements even if caused by short-term phenomena. This policy aims at anchoring inflationary expectations, and for most Indians, perceptions of inflation are formed through food and fuel prices, as these are daily needs.
Here’s why the full Consumer Price Index basket must be used. First, the target inflation metric has to be representative so as to capture the true cost of living and be aligned with people’s daily experience.
Second, the representative basket must be updated more frequently, say, every three years to reflect changing consumption preferences. For instance, people are spending more on mobile services and are eating out, which affects their food spends.
Third, we now have digital tools to get almost real-time movement of prices; this can be done by calculating a price index based on retail transactions captured on the GST network. The data is anonymized, can be computed separately for sub-categories like food, clothing and durables. And as the GST net expands, it will become more representative of the entire consumption basket and spending patterns.
Fourth, overall price stability can be ensured and is consistent with big changes in relative prices. Healthcare costs could be rising while smartphone costs fall, with inflation remaining stable. This reflects the changing structure of the economy even though the general price level remains stable.
Stable inflation with changing relative prices perform an important signalling role, guiding the flow of private investment in augmenting supply capacity toward sectors that exhibit higher demand and stronger relative prices. This signalling role gets corrupted if there is high and volatile overall inflation, making it harder for consumers and investors to take decisions.
It is private investors and markets that spur growth through their decisions, not government spending, which can help sustain growth in the medium to long term.
In India, it has been repeatedly shown that interest rates alone do not determine investment decisions, which tend to go by the overall investment environment, demand outlook and policy stability. RBI has much ground to cover before inflation stabilizes at the 4% mandated level. Till then, a relatively tight monetary policy is justified.
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