National Council of Applied Economic Research
Opinion: Poonam Gupta.
In the recent Jackson Hole Conference, the Central Bank governors of the US, Europe, and Japan reaffirmed their commitment to inflation targets of 2 percent. They resolved to continue raising the policy rates and keeping them “higher for longer”, in pursuit of this target.
The subtext of their speeches contained important nuances. First, inflation rates may remain above targets for months, or even years, to come. Second, monetary policy may not be as effective during the last stretch of their war on inflation, as it was at higher levels of inflation. Third, global shifts (attributed to an aging population, economic fragmentation, climate transitions, and sticky fiscal positions) will likely elevate the level of structural inflation.
These messages hold relevant implications for inflation management in India.
Inflation Target: Higher level, narrower band?
India’s headline inflation has averaged 5 percent since the adoption of inflation targeting (IT) in 2016. It has remained within the mandated band of 2 to 6 percent, barring two years, 2020-21 and 2022-23, when it exceeded 6 percent amidst external shocks. However, achieving the inflation target of 4 percent has remained elusive.
Since 2016-17, core inflation rate has averaged 5.3 percent a year. While food inflation has averaged a more modest 4.7 percent annually, but it has been three times as volatile as the core inflation.
In view of this record and the prognosis for inflation globally, India may consider revising its inflation target as well as the band.
Most of the large emerging markets economies target inflation at 3-4 percent, with bands of 1-1.5 percent around them: Brazil’s inflation target is 3.25 percent, with a band of 1.5 percent; Indonesia’s inflation target is 3 percent, with a band of 1 percent; Mexico’s target is 3 percent, with a band of 1 percent; and South Africa targets a range 3-6 percent, with no targeted level. These countries, having attained their previous targets, have successively lowered their targeted level of inflation and tightened their bands over time.
In comparison to the other emerging markets, India has not revised its IT framework since its inception seven years ago, continuing to maintain the inflation target of 4 percent and a wider band of 2 percent.
This is despite the fact that it has not been able to achieve a 4 percent headline inflation rate during six of the eight years; and its core inflation has far exceeded 4 percent for the majority of these years.
The credibility of its IT would likely enhance it if moves its target rate of inflation upward, and simultaneously makes the band narrower in order to commit more credibly to the new target.
For example, in due course it could increase the inflation target to 4.5 percent, situated within a narrower band of 3.5-5.5 percent. Other similar alternatives would be worthy of consideration too.
An obsolete Consumer Price Index (CPI) basket needs periodic revisions
A revision in India’s obsolete CPI basket will help deliver the mandate of monetary policy better.
While countries such as Brazil, Mexico, South Africa, and Turkey typically assign weights of 17-25 percent to “Food and Beverages”, and advanced economies assign weights of 7-10 percent to it, India assigns a much higher weight of 46 percent.
Other countries revise their baskets at regular intervals of 1-5 years, but India has not revised the basket since 2001. This is despite the fact that in the interregnum per capita income has tripled and the shares of both agriculture and food in GDP have halved from their earlier levels. With the extent of such transformation, its current weight of food in consumption is likely only 30-35 percent.
The prevalent large weight of volatile food prices in CPI leads to volatility in the headline inflation. It makes the discourse on monetary policy noisy, leading to calls or temptations for actions despite the fact that monetary policy is a blunt instrument for tackling food inflation.
With the updated weights, say a 30 percent weight of food and a concomitantly higher weight of the core in the inflation basket, India’s headline inflation would become more stable, bringing predictability to its monetary policy.
Towards a nimbler framework
A nimble and flexible IT will remain the framework of choice for most countries, including India, in foreseeable future. Anticipated higher structural inflation would be best served by a resolute monetary policy implemented collaboratively with fiscal, regulatory, and trade measures.
A fast-growing economy such as India ought to update its policy frameworks and institutions on an ongoing basis. A sensible way to do so would be to commit to the revisions in the IT framework, and the CPI basket every 5 years. The Reserve Bank of India ought to be entrusted with both these tasks.
Such revisions would make the conduct of monetary policy both credible and relevant in a fast-evolving world.