Avoid haste on shift to core CPI

Should India’s inflation targeting framework target the headline Consumer Price Index (CPI) or just its core, namely, the non-food non-fuel part? This year’s Economic Survey set the cat among the (monetary policy) pigeons by arguing that the latter might be better than the former, and a report in HT suggests that the government is working on reconstituting CPI with a lower weightage of food. Is this a good idea?

Inflation targeting, at a theoretical level, is supposed to use interest rates to maintain a healthy balance between inflation and growth. The idea comes from the principle that production capacity in an economy is fixed in the short-term but can be expanded over the long-run. If demand starts running ahead of supply, higher interest rates can generate headwinds for consumption and investment and ensure that demand returns to levels which are aligned with existing productive capacity or potential growth rate.

Should such a policy be bothered about movement in overall inflation because of, say, a supply-side shock in onion or tomato markets? Nobody borrows money from banks to buy vegetables. Mechanically raising interest rates in response to supply-side shocks for vegetables might generate unwarranted headwinds for overall growth in the economy. This is exactly what some commentators, including the finance ministry’s Economic Survey, have argued.

Tempting though the idea is, it has a serious problem. Because inflation targeting is a forward-looking exercise — higher interest rates today are expected to contain inflation tomorrow — inflation expectations are the most important input in making policy decisions. Given food is a significant part of the consumption basket in India, it plays a crucial role in shaping inflation expectations. Political discourse on inflation almost always revolves around onions, edible oil and fuel rather than services or household durables. Core inflation captures the latter and not the former. Any decision to align inflation targeting to core rather than headline inflation must come up with a sound method to capture core inflation expectations. And this is easier said than done.

This is not to outrightly dismiss the valid growth concerns vis-à-vis the current inflation targeting framework but only to underline the real-life pitfalls of trying to marry economic principles with practical concerns and socio-economic realities.

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