Rising food prices, MSP hikes to test RBI's inflation-targeting framework

Thereafter, despite continuing global turmoil from multiple sources in the last four years or so, the flexibility embedded in the FIT framework has helped us effectively address these unprecedented challenges while supporting growth. Monetary policy in India was able to respond to the economic slowdown decisively and swiftly in the wake of the pandemic and again pre-emptively during the build-up of inflationary pressures after the war began in Ukraine in early 2022. The prevailing well-balanced growth-inflation dynamics is a testimony to the success of the FIT framework."

Deputy governor Michael Patra, speaking at a recent conference on central banking was equally evocative and emphatic: "The journey of inflation targeting (IT) has been tumultuous, navigating as it has the Great Moderation and ‘once in a century’ shocks such as the global financial crisis (GFC), the Covid-19 pandemic, and persisting geopolitical conflicts that have had a direct bearing on both inflation’s evolution and on financial conditions. Yet, there is no evidence of any major country abandoning it," said Patra. "The endogenous evolution of IT has rendered it the longest surviving monetary policy framework in modern times," he added.

Even as he drove home the triumphs of the flexible inflation targeting framework in India, Patra pointed out the challenges it faced in terms of how to tackle financial instability caused by global spillovers when developed markets like the US sharply raise rates or when the yen carry trade unwound. He went on to point out how the FIT framework will have to be nimble to tackle challenges from climate change disasters, and digital era challenges.

RBI's worry is not fickle veggie prices. Its bigger worry is that despite a heavier-than-average monsoon, cereals were up 0.7 percent in September over August, while pulses were up 0.6 percent. This translates to an annualised rise of around 8 percent for cereals and over 7 percent for pulses in what looks like a good year for food grains.

The problem with food prices in India is somewhat structural and political. As Niti Aayog member Ramesh Chand pointed out in an interview, "In the case of cereals, much of what you will watch happening in the market is the translation of what we do to MSP (minimum support price). If we are increasing MSP by 6 percent, 5 percent, and some little factor adding from market, it takes it to 8 percent and 9 percent..."

Chand argues that MSP should ensure that farmers get back their investments, i.e. they don't make losses. But lately, thanks to the A2+FLx1.5 formula, there has been an inbuilt structural annual 5-6 percent addition to food prices. "I have never seen in the history of CACP (Commission for Agricultural Costs and Prices) that you have even reduced price by even a very small amount from a high level in previous years," says Chand. "So, if, because of shortage, a high rise is given in one year, that becomes a base for further rise next year."

What Chand is pointing out is that the MSP is no longer a market mechanism. It's politically set to placate farmers. The recent rise in the import duty of oilseeds is, similarly, a political decision to enrich farmers.

Already, one of the strongest points against RBI adopting an inflation targeting framework, was and is the fact that it can't impact food prices with interest rates, and in India's case food enjoys a huge 49 percent weight in the CPI.

And now, if food prices are driven up by a political lobby, and an annual rise is hard coded into the MSP, the RBI may increasingly find its 4 percent CPI target more and more elusive.

The answer lies in helping farmers differently, says Chand. It may be through other schemes like compensating for price falls or some other form of insurance. But at the moment, the MSP and its A2+FL formula are politically impossible for the Modi government to dislodge.

It looks like the hardest challenge for FIT will emerge in the coming months.