Why The MPC Should Only Target Non-Food And Non-Fuel Inflation

Recently, a former deputy governor of Reserve Bank of India mentioned the need to put one in the shoes of the poor who primarily have food and fuel as a major item in their consumption basket.

He mentioned this as a response to those who asked for 6 per cent inflation. The entire controversy is an outcome of reports suggesting the prospects of government increasing the inflation target given the persistently high inflation levels.

There are two important issues that deserve a lot of attention here, given the discussion about inflation, inflation targeting and the important role of monetary policy.

One must thank the former deputy governor for highlighting the critical difference in consumption baskets of various people based on their income distribution.

The poor spend a major part of their consumption expenditure on food and fuel and as their income levels increase, their share of consumption expenditure on food and fuel reduces.

However, in the event where we give food subsidies in kind, in the form of foodgrains such as wheat and rice, the consumption expenditure in reality for those who are entitled to food security goes down.

The point here is that consumption on food does not get curtailed, but rather, it is the non-food consumption that gets contained during high persistent inflation.

What about food inflation? For those benefiting under the subsidised food grains, the nominal value of food transfers goes up when the price of wheat and rice goes up. It is vegetable prices that are critical here. For example, high prices of onions and tomatoes would have an impact on the poor’s consumption basket.

The next question is does high inflation in general, especially food and fuel, impact the poor adversely or does lower growth hurt them more? This is a question that has become far more critical at the given moment — and perhaps, was also critical during the Volcker tenure in the US.

In the context of India, given that the economy is yet to recover form the pandemic-induced shock, it is important to give growth a priority. It is important to view what happens to wages data with inflation, as at the end of the day, we want wages to grow and labour markets to be tight.

A higher growth leading to tighter labour markets and higher nominal wage growth as long as real wage growth is positive would be the sure-shot way to ensure a fast pace of poverty alleviation.

This makes it important to evaluate what is the permissible rate of inflation that we are willing to tolerate and for how long to support growth.

Six per cent inflation does not look that high provided it helps us achieve a 12-13 per cent nominal growth rate, leaving us with a real growth of 6-7 per cent per annum.

Also important to note that 12-13 per cent nominal growth rate also means faster pace of tax revenues growth as tax revenues depend on nominal growth rates — thus, greater tax revenues would leave with more resources to redistribute or finance investments that can lead to greater growth in future.

But the question is not whether we should target 4 or 6 per cent of inflation, as achieving 6 per cent inflation will remain a task for the RBI in India unless the government adopts policies to achieve the same.

That is, the only way to ensure inflation is at 6 per cent is to have a high food inflation, which depends extensively on the MSPs and subsequent increases on a year-to-year basis — or on agricultural shocks such as droughts.

If we ignore food and fuel for a second — since they both are a function of government policy, the rest of the components do depend on monetary policy. However, across the world, central bankers are waking up to recognise the issue with accelerating inflation — that is, you can bring down inflation using conventional monetary tools; however, once inflation is down, it is difficult to move it above the target should the central bank wish to do the same.

On food and fuel, given that they are not a function of RBI or MPC’s policies, the only question is why have them as part of the target when the MPC can do nothing about it?

Even if it were to hike interest rates, the impact on inflation print will come through other items and given the high share of food and fuel prices in the CPI index, a substantial reduction in inflation or disinflation of other items might be needed to bring the target down to the permissible range of 2-6 per cent.

The fundamental point here is that since the MPC’s policies will do little to bring down food or fuel inflation, how do we deal with a situation whereby food and fuel inflation is higher, and it feeds into general inflation?

The answer would be, perhaps, to revisit the discussion on the choice of indicator for inflation targeting rather than tinkering with the permissible inflation limit.

Non-food and non-fuel CPI could be a better target for the MPC, while the RBI and MPC can enter into an agreement that puts some constraints on the government so as to keep food and fuel inflation in check.

We must, however, recognise and accept the limitations of monetary policy in curbing our present indicator of CPI given the high share of food and fuel.