‘Inflation’ shouldn’t exclude food

The Economic Survey (ES) of 2023–24 made a suggestion that food inflation could be ignored while targeting inflation. Monetary policy measures focus more on demand-side factors to curb prices, while supply-side factors predominantly drive food prices.

Though the effectiveness of inflation targeting in containing inflation remains largely inconclusive in research findings, the suggestion to exclude food from inflation targetting has been met with scepticism from many economists.

Can we exclude food items that constitute almost half the consumption basket from inflation targetting and worry only about the non-food inflation? Research shows that monetary policies of low and middle income economies should target headline inflation rather than only core inflation.

Inflation Targeting Regime

The multi-indicator approach followed by the Reserve Bank of India before the inflation targetting regime came under criticism due to the co-existence of high inflation and poor growth rate, especially after the Global Financial Crisis of 2008.

Subsequently, India adopted flexible inflation targeting (FIT) in May 2016, following an amendment to the RBI Act. The RBI’s target of consumer-price-index-based inflation is 4 per cent, with a tolerance band of 2 per cent on either side.

Currently, around 45 central banks worldwide have adopted the inflation targetting framework, with New Zealand being the first country to adopt it.

While experiences from countries such as Canada, New Zealand, Australia, Spain and the UK show that inflation remained within or close to the target range or rate, several other countries that did not follow an inflation targetting regime also experienced moderate inflation rates.

Empirical findings also show that higher exchange rates and world prices pass through to domestic prices, especially when domestic overall inflation and food inflation are high.

After dropping to 4.75 per cent in May from this year’s peak of 5.10 per cent in January, India’s retail inflation further jumped to 5.08 per cent in June. This was contrary to the expected rate of 4.80 per cent. The primary driver of this increase continues to be food inflation, which stands at 9.36 per cent.

In April, when overall inflation was 4.83 per cent, food inflation was 8.70 per cent. Food items constitute 39.06 per cent of the consumption basket, with a slightly higher weighting for rural (47.25 per cent) than for urban (29.62 per cent). Within this, cereals and cereal products have the highest weighting at 9.67 per cent, followed by milk and milk products at 6.61 per cent and vegetables at 6.04 per cent.

Consumption Expenditure trends

According to the Household Consumption Expenditure Survey (HCES) for 2022–23, food items continue to have a greater share in total household expenditure for both urban and rural households, though this share has declined in recent years.

On average, food consumption accounted for around 46.4 per cent of total monthly per-capita consumption expenditure (MPCE) in 2022–23 for rural India. The corresponding figure for urban population was 39.2 per cent.

In 2009-10, the figures for rural and urban populations were 57 per cent and 44.4 per cent, respectively. Not only did the share of food in total household expenditure decline, but there has been a compositional shift within the food consumption basket — from starchy cereals to animal and horticulture products. The percentage share of cereals in average MPCE declined from 13.8 per cent in 2009-10 to 6.9 per cent in 2022–23 for rural population.

For urban population, the share dropped from 8.2 per cent to 4.5 per cent. The milk and milk products, eggs, fish, meat and vegetables constitute one of the highest shares among the food items in the MPCE.

Though there has been a compositional shift towards non-cereal items and a marginal decline in the share of food in MPCE, food expenditure still constitutes a major chunk of the food basket of both rural and urban populations.

Way Forward

Although deploying short-term monetary policy tools, which largely focus on demand-side factors, may be counterproductive given that rising food prices are mainly due to supply-side factors, excluding the food items that constitute almost half of India’s consumption basket is a cause for concern. In many countries such as Thailand, which has an inflation targetting regime, monetary and fiscal policies are well coordinated to tackle inflation.

Any surge in food prices may pose a threat to inflation targetting, as high food prices can lead to higher inflation expectations.

Current food inflation trends are less transitory as they tend to be persistently high. Food is an important input in the production of several non-food items; therefore, an increase in food prices can also raise the prices of non-food items, putting the inflation targetting regime in jeopardy.

What India probably needs to do is reconsider the weights in the CPI basket, ensure the smoothening of supply-side shocks to regulate domestic food prices, and remove certain items, such as vegetables, from the focus of inflation targetting, since the vegetable prices are more volatile but transitory.

The current weightage of vegetables in the consumption basket is quite high at 6.04 per cent. Only cereals and cereal products (9.67 per cent) and milk and milk products (6.61 per cent) have higher weightage than vegetables in the consumption basket. The inflation rate for April 2024 also shows that vegetables exhibited the highest rate of inflation, 27.8 per cent.

This is followed by pulses and products, which highlight the excess domestic demand despite an import surge and a series of government interventions to boost domestic production.

Additionally, caution is required to tackle the impact of currency depreciation on exchange rate pass-through, especially for imported food items such as edible oils and pulses.

The writer is a faculty at IIM-Ahmedabad. Views expressed are personal