Inflation refers to the percentage change in prices. That’s what the
text book says. But the way we look at this number varies across countries, and
also changes with the purpose. Inflation is the target for central banks and
there is a lot of focus on this number all through the year, especially when
high.
Interpretation is hard because it involves a lot of subjectivity. Hence,
one tends to look at the headline number. This becomes a good anchor for
central banks. But often the peg is driven by components which may not be
influenced by monetary policy. The first that comes to mind is food, as
interest rates cannot affect their prices under normal conditions. People
rarely borrow to buy food. Higher interest costs can push up costs for
manufacturers of food items, which could add to inflation, but that is a
different thing.
What central bankers talk a lot about is core inflation, as it is more
sensitive to interest-rate movements. This is the non-food-non-fuel component.
This concept, though widely used, has been debated in the Indian context
because one may not be using leverage to pay rent or buy cosmetics or a cinema
ticket. We may borrow for healthcare or education, but then cost is rarely a
limiting factor for their demand. Besides, in India, the use of credit cards is
still not high, accounting for just 1.5% of total credit. This is unlike the
US, whose citizens live on credit and respond to rate changes. Then there are
other inflation concepts such as ‘core-core’, which excludes petrol and diesel
products, and the ‘super core’, which takes rent out of it too. These are
creations of economists who use them in different contexts.
India’s headline inflation numbers came down in May but increased in
June. However, core inflation has come down and held steady at 5.1%. Is one to
be happy about it? One cannot be sure. The Reserve Bank of India’s (RBI)
central target is 4% headline inflation. It was less than 4% in 2017-18 and
2018-19. In 2019-20, it was at 4.8%. But then the storyline changed, with
inflation twice going above RBI’s 6% upper tolerance limit, while it was at
5.5% in 2021-22. This suggested that earlier low readings were more a result of
chance, as India has traditionally had inflation above 5%. With inflation now
high again, comfort is being drawn from the fact that it is less than 6%. This
also means that June’s inflation at 4.8% is acceptable.
But using the economist’s wand, the number of 4.8% in June or 4.3% in
May can be tweaked. Food inflation was a challenge in both months, with
cereals, pulses, milk, spices and prepared meals witnessing high inflation. But
a sharp fall in oils-and-fats inflation (-16% in May and -18% in June) brought
down headline inflation, as the category has a 3.6% weight in the index. If
this is excluded, inflation would be closer to 6% and RBI is aware of that.
Inflation numbers are also influenced by base effects. In the case of
tomatoes, for example, for which market prices have crossed ₹200 per kg in
some parts of Mumbai. But with a weight of around 0.6%, they have shown negative
inflation for the last three months, with the latest being -35% in June. This
reads odd, but it is a statistical reality, as the base was high last year,
which has given us such a counter-intuitive outcome.
Using inflation numbers for policymaking is a challenge due to base
effects and the spikes or troughs caused by single commodities. The RBI’s
mandate is to target the consumer price index (CPI) headline number, which can
be too capricious. Using core can be a way out. Currently, it features in explanations
but isn’t used to anchor the target. Prior to the CPI, the wholesale price
index (WPI) was used as a target. The rationale was that the WPI is influenced
by interest rates as it is a producers’ price index. These are the conundrums
we face in choosing an inflation target for India.
Interestingly, what goes into the index is also important. Often, we
tend to compare US inflation and the policy action of the Federal Reserve with
that of RBI. But our indices are different. The CPI in the US is impacted more
by the Fed rate because of high household leverage. Here a comparison with the
components is also quite insightful.
In India, the food basket has a weight of 45.9% in CPI at the all-India
level. For the US, it is just 13.4%. The decisive component in the US index is
housing, with a weight of 34.5%, while for India, that is much lower at 10.1%.
This can also be associated with the mortgage industry, which is huge in the
US, while this segment in India has come into focus only recently. In the US, services
dominate the CPI index with a collective weight of 58.2%, and transport,
recreation, education and medical prices together account for 20.2% of the
index. In our index, these form under 10%. The weight of garments-related
products is higher in India at 5.6% than in the US, where it is 2.6%.
Thus, even if we compare the CPIs of different countries, the factors
driving them are different as the components vary to reflect the consumption
patterns of respective societies. As another example, when we talk of how
easing global commodity prices can soothe inflation, it may have little effect
if these retail prices are not market-set.
All this means that inflation targeting is complex and central banks
have to monitor and target the relevant components to make policy work
effectively.
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