The economist Milton Friedman had said that inflation is always and everywhere a monetary phenomenon. That is how monetary policy came to the forefront with inflation targeting being the result. An issue which has come up particularly in India is that if inflation is being driven by food products over which monetary policy has no control, are we barking up the wrong tree? As a corollary, some arguments suggest that the share of food in the index should come down or that the central bank should be targeting core inflation which excludes food and fuel. These issues are prima facie pertinent but deserve further probing.
The answer is not straightforward even when one talks of food inflation. While overtly it does seem that supply shocks lead to higher prices there is a demand factor also at play. For example, demand for coarse cereals has been rising over time with the society being driven by health motivations. This has increased the prices of the products. The same holds for cereals where value added products are driven by demand conditions and often not related to supply-side factors. Besides with an open-ended procurement programme run by the Food Corporation of India a lot of grain gets diverted, leaving less for the market in the face of rising demand. At times, such diversion leads to excess demand in markets, which pushes up prices.
Higher incomes make people move to higher-value products, which play in the background. This is but natural. The proliferation of catering, hospitality, and travel businesses has added to the demand of edible oils. A similar example is pulses (especially chana) whose prices rise during festivals due to exceptional demand.
Further, leverage is used for the purchase of goods at supermarkets by even lower income groups. Personal loans have grown at a smart rate across all segments where interest charged has a bearing on purchases. Thus, there is merit in the link between interest rates and demand for food. The problem comes to the fore when there are supply shortages and sharper price increases. Interestingly, even the “core inflation” products do not always witness price rise due to demand factors alone. The increase in, say, telecom prices has nothing to do with demand which remains inelastic once it is a habit. Similarly, when hospitals or educational institutions increase fees, it is not due to demand but the “cost factor”. The cost will include staff salary as well as cost of other inputs going into the service. The same holds true for consumer products, where higher input costs are not driven by demand but global and domestic factors that feed into the final price.
Hence it can be argued that price changes for non-food products are also driven by supply. Further, housing price included in the index is linked to the house rent allowance of government officials, which too is a periodic change and not a demand-side factor though high demand increases housing rent in the real world. It can be countered that with the boom in housing the supply of tenements for rent would always be increasing and often the movements in rent are sluggish.
Therefore, it is hard to distinguish between price increases due to pure demand or supply factors. Both are at play and separating the two forces on the assumption that product (or service) prices are driven exclusively by one can lead to erroneous conclusions. Today, retail credit is the leading segment which involves households. Higher interest rates do keep a check on spending based on leverage as budgets are realigned. Hence even if, for the sake of argument, it is assumed that the food price shock is purely due to supply factors, interest rates have a bearing on household borrowing and hence spending, making policy very relevant.
The problem with food inflation is that when it is high, it feeds into inflationary expectations which then spreads to core inflation and over time becomes generalised. This happens in two ways. One, when there is an upward adjustment of incomes, including wages, which in turn trigger demand pull forces for other non-food products. The Mahatma Gandhi National Rural Employment Guarantee Act wage, which is a benchmark for wage setting in other sectors, gets adjusted with inflation every year and hence automatically increases incomes in other professions. Second, there is a tendency for producers of manufactured goods to also raise prices once food price inflation is anchored at a high level. This happens with a lag of two-three quarters. In fact, often producers absorb higher input costs to begin with before transmitting the same to the final consumer. For example, higher wages paid by movie theatres get reflected in higher ticket prices.
Therefore, it may not be prudent to ignore food inflation from the point of view of monetary policy as there are strong linkages with other parts of the price index. Further, by keeping interest rates higher when food inflation is high, it helps in preventing the build-up of excess demand pressures. This is why it is often argued that monetary policy has to be reactive and keep looking continuously at the rear-view mirror. The precise impact of food shocks on inflation is hard to guess. The price shocks either last for a couple of weeks, or get entrenched in the system and become durable.
This is why it is observed that central banks target headline inflation and do not ignore food inflation. In India especially, consumption trends of food products have changed greatly with demand-side factors coming into play. Ignoring this aspect of inflation will mean missing one significant piece of the puzzle.
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