Inflation Targeting in India: A Balancing Act Between Headline and Core Inflation
India's monetary policy is once again at the center of an intense debate, as the country grapples with the question of whether to continue targeting headline inflation or to shift focus to core inflation, which excludes volatile food and fuel prices. This discussion is not merely academic; it has profound implications for the Reserve Bank of India's (RBI) policy decisions, the broader economy, and the everyday lives of millions of Indians.
The Current Framework: Headline Inflation as the Target
Since adopting the inflation-targeting framework in 2016, India has aimed for a 4% headline inflation target with a tolerance band of +/- 2%. This framework was designed to anchor inflation expectations and provide a clear benchmark for the RBI's Monetary Policy Committee (MPC) when setting interest rates. However, the persistent challenge of high food prices has kept headline inflation above this target, despite core inflation—often viewed as a more stable measure—falling to historically low levels.
The Debate: Headline vs. Core Inflation
The recent suggestion, floated in the government's annual economic report, to target core inflation instead of headline inflation has sparked a vigorous debate. Proponents argue that core inflation provides a more accurate reflection of underlying price pressures in the economy, free from the short-term volatility of food and fuel prices, which are often influenced by supply shocks.
However, external members of the RBI's MPC, including Shashanka Bhide, Jayanth Varma, and Ashima Goyal, have voiced reservations about such a shift. Their concerns highlight the complexities of monetary policy in a country like India, where food prices are a significant component of household consumption.
Shashanka Bhide's Perspective: The Whole Basket Matters
Shashanka Bhide, an external member of the MPC, emphasizes the importance of considering the entire consumption basket when targeting inflation. He argues that focusing solely on core inflation would ignore significant price pressures from food and fuel, which are critical to understanding the real impact of inflation on the economy. "If we use a partial basket for a target, then it would not reflect the overall price pressures," Bhide told Reuters. He adds that any shift to targeting core inflation would need to account for trends in food and fuel inflation, even if not their volatility.
The Risks of Ignoring Headline Inflation
One of the key risks of shifting the inflation target to core inflation is the potential disconnect between monetary policy and the inflation experience of ordinary citizens. In a country where food comprises a large portion of household expenditure, headline inflation has a direct impact on living standards. By focusing on core inflation, the central bank might miss out on addressing the inflation that matters most to the public.
Ashima Goyal, another external MPC member, reinforces this point by noting that while headline inflation may converge with core inflation over the long term, it is headline inflation that affects the public more immediately. "Headline is the inflation that impacts the public more," she said, suggesting that the MPC should still pay significant attention to core inflation without entirely shifting its focus away from the headline measure.
The Role of Food Inflation: A Persistent Challenge
The persistence of high food inflation in India poses a unique challenge for monetary policy. The MPC has kept the key repo rate steady at 6.5% for nine consecutive meetings, largely due to elevated food prices. This has limited the committee’s ability to cut rates, despite the decline in core inflation, leading some analysts to question whether the current inflation-targeting framework is too rigid.
Jayanth Varma, who has consistently voted for a 25 basis point rate cut, highlights the difficulties posed by high food inflation. He points out that even if the target were shifted to core inflation, the concern about food prices spilling over into core inflation would remain. This spillover effect is crucial because it can lead to broader inflationary pressures, undermining the stability of the economy.
A Broader View: The Need for a Balanced Approach
The debate over whether to target headline or core inflation underscores the broader challenge of designing a monetary policy framework that balances the diverse needs of the Indian economy. On one hand, there is a need to maintain price stability and anchor inflation expectations; on the other, there is a need to be responsive to the inflation that directly affects people's lives.
One possible approach is to maintain the headline inflation target while giving more weight to core inflation in the MPC's deliberations. This could allow the RBI to be more flexible in its response to inflationary pressures, particularly when food prices are volatile due to supply-side factors that monetary policy cannot directly address.
Navigating the Path Forward
As India continues to navigate the complexities of inflation targeting, it is clear that there are no easy answers. The decision on whether to stick with headline inflation or shift to core inflation as the primary target will have significant implications for the economy and for the credibility of the RBI. What is essential is that any decision should be made with a clear understanding of the trade-offs involved and with a focus on maintaining the delicate balance between price stability and economic growth.
The ongoing debate highlights the need for a nuanced approach to monetary policy—one that considers the unique characteristics of the Indian economy and the lived experiences of its people. Whether the target remains on headline inflation or shifts to core inflation, the ultimate goal must be to ensure that the benefits of a stable and predictable inflation environment are felt by all.
