The repo rate has remained at 6.5 per cent for long, and there is a strong difference of opinion within the Monetary Policy Committee (MPC) on the next course of action. Those favouring a reduction argue that high interest rates hamper investment as capital turns costlier. While there is no evidence for this, as high rates in the past have not hindered borrowing nor have hyper-low rates for two years increased borrowing, it is nevertheless a sound theoretical argument.
The consumer price index (CPI) is loaded in favour of food products, which cannot be influenced by interest rates anyway. In fact, the argument also favours overhauling the index composition. The government’s consumer surveys recommend a lower weightage for food products as this may lead to lower headline inflation. This also accords more importance to targeting ‘core inflation’, which excludes food and fuel items.
Industry, as always, favours lower interest rates and echoes these arguments on core and food inflation. With core inflation currently at about 3 per cent, it naturally bolsters the ‘cut repo rate’ argument.
Price movement
Yet another line of thinking questions the need to tackle headline inflation, which is dominated by food items. However the RBI governor has, in the latest policy, taken a clear stand on this by explaining that food inflation cannot be brushed aside as it can feed into core inflation and, hence, headline inflation. Besides, globally, central banks tend to target headline inflation. While core inflation is looked at seriously and is part of the discourse, it is never the target. In this context it would be interesting to see how core inflation has played out in India over the last 14 years.
The accompanying table gives the frequency distribution of 150 monthly inflation points under headline CPI, core CPI and non-core CPI across ranges.
There are some interesting observations here. The average inflation in India was 5.9 per cent since 2012, with both core and non-core inflation averaging 5.8 per cent and 6 per cent, respectively. What this means is that all prices move at almost the same pace over a longer period of time.
Second, the distribution is quite revealing. Core inflation has remained above 4 per cent in 89 per cent of the months and above 5 per cent in 61 per cent. Therefore, core inflation has not remained low all the time.
Third, food inflation has remained below 4 per cent about 31 per cent of the time and above 6 per cent almost half the time. This means there are big swings in both the lower and upper ranges for non-core inflation. This is so because supply shocks are either negative or positive, which keeps prices volatile. Food inflation can turn negative if prices fall, while this has never happened for core inflation because companies rarely lower the prices of goods and services. Hence headline inflation can swing in both directions due to food inflation. Core inflation, on the other hand, has generally tended to remain above 5 per cent.
Need for narrow band
The median value of core inflation would be around 5.1 per cent. It is 5.7 per cent for non-core inflation and 5.4 per cent for headline inflation. With such a distribution it does appear that even if the MPC were to target core inflation and not headline inflation, the numbers would not really vary from the current situation. It can thus be argued that there is a case for changing the inflation target of 4 per cent. Past data would indicate a meaningful target of around 5 per cent, with the band set around this number. The band of 200 bps can, however, be reviewed and a lower 100 bps would be consistent with 5 per cent target.
A review of the inflation target is essential as the dynamics of inflation has changed for sure. The broader question is whether the target should be headline or core inflation. Arguably, core inflation is driven by demand forces and, hence, interest rates have an influence here. But, as seen from the data presented, the number will not vary much from a similar range of 5 per cent. The band can also be reviewed because it is currently 50 per cent on both sides of 4 per cent, which is quite wide and difficult to interpret for the markets. A narrower band could be considered instead.
(The writer is Chief Economist, Bank of Baroda, and the author of ‘Corporate Quirks: The darker side of the sun’. Views are personal)