Does Core Inflation Really Matter: 17th July 2008

Economists argue the RBI's actions would be different if it targeted 'core' inflation - but using this wouldn't really change things argues.

A concept that has become pertinent today is core inflation. Central banks are supposedly looking at core inflation now because it is felt that what needs to be affected by monetary policy is not ‘general' inflation but ‘core' inflation. What is this concept and in our own context, which of them should be tracked?
Core inflation, as the name suggests, is basically inflation that is not peripheral and is ingrained in the system. To be more specific, this theory says that food and fuel prices in particular are peripheral as they are affected by the prevailing environment and may not hold forever, being essentially transient in nature. In fact, they are supposed to be mean-reverting, implying thereby that while these prices may go up in the short run due to some disturbance in the farm sector or oil economy, they would tend to revert to equilibrium in the medium run. And such inflation is really out of the purview of anyone — after all you cannot stop the OPEC from raising prices nor can you counter the shortfall in farm production by pushing prices down artificially for a long time. This means that what matters are the prices of other products that will not tend to asymptotically move back towards a hypothetical normal. In case of the other goods, their prices would tend to be sticky in the downward direction and hence all increases could be taken to be of a permanent nature. If this is so, then the central bank should logically target only core inflation.

Now, the concept of core inflation can be contested since when we assume that inflation of food and fuel products returns to a normal, it is too simplistic an assumption to make. Oil prices are increasing world over and it would be absurd to think that these prices will go back to the double digit levels of, say, 2006. The same holds for food prices. When they rise, and so does general inflation, this number gets factored in by farmers when they are fixing their prices for the next crop. Under these conditions, they will not go back to the normal but will raise it above this level. Hence, this level will keep moving along gradually in the upward direction along with the inflation line. Therefore, even when there is a good harvest, there is only a partial correction in prices as farmers have to buffer in the increased cost of living caused in the previous cycle on account of inflation. Further, since the food crisis today is on account of a fundamental shift in cropping pattern globally due to biofuel consideration, it is unlikely that the higher prices today will actually dip to the low levels of 2006 or 2007.

Even so, from the point of view of an academic discussion, it would be interesting to see what variations in inflation have been seen in India in the last quarter of a century with respect to core and general inflation . Core inflation here excludes food and related manufactured products and fuel products. The core inflation products account for approximately 65 per cent of the present WPI when cereals, pulses, oilseeds, manufactured food products and fuel products are excluded. The above table has information on the two inflation rates averaged across five year periods for the last 25 years.

One feature that stands out is that there has not been much of a difference between general and core inflation in the Indian context. The difference at best has been one percentage point and there has been no definite trend as such in terms of widening or narrowing down over this period of time. However, a micro-analysis of the same reveals that in the period up to 1990, differences between the two were over one percentage point in six out of eight years. Further, in six out of 25 years, core inflation was actually higher than the general inflation rate, which could be explained by the fall in primary product prices due to good harvests. However, the same has not been observed of late, when harvests were good. In fact in 2007-08, when agricultural production peaked, the difference between the two rates was maintained at 0.8 per cent. Again, in 1996 and 1999, there was a difference of as much as 3 percentage points between the two, which could be attributed to higher farm prices.

However, on a long-term basis, core inflation appears to be not more than one percentage point different from the general inflation rate. This may be explained by the inherent upward pressure exerted by general inflation on future food prices that makes a large part of the increase in food prices permanent in nature. Oil prices are administered and are rarely reduced, given the fact that products are heavily subsidised by the government and oil companies. Therefore, this component too becomes more or less permanent in nature.

Therefore, when it comes to inflation targeting, the RBI will not really be off the mark by tracking the general inflation rate. Also, the fact that the difference is very small would mean that we cannot talk differently of a core inflation number as this rate varies with the general inflation rate. Hence, we will have to continue expressing our ‘desired inflation rate' as the ‘targeted rate' and not the ‘core inflation rate'.