Target headline or core inflation? Depends on where you sit

Ever since, economists have discussed merits and demerits of targeting headline vs core inflation. Targeting headline means you are not excluding any component but then you are open to high volatility creating problems for monetary policy. Targeting core means you are doing away with the problem of volatility but excluding a major portion of the CPI index.

The debate of headline vs. core intensifies when the headline inflation becomes higher than core due to shocks on food and fuel markets. The central bank comes under pressure during such times and its monetary policy faces a dilemma.  The focus on headline inflation suggests a tight monetary policy stance whereas focus on core inflation suggests an easy monetary policy stance.

Core inflation trajectory since January 2023

Coming to India’s inflation trajectory, RBI is facing similar dilemma. The core inflation has declined from a high of 6 percent in January 2023 to 3 percent in May 2024 before rising to touch 3.7 percent in October 2024. Headline inflation on the other hand has remained higher than target inflation of 4 percent in the same period and even breaching the upper band level of 6 percent few times. Headline had started to decline in the months of June and July 2024 but has again gone up in last few months to touch upwards of 6 percent. The rise in headline is because of swings in food prices particularly fruits and vegetables.

The divergence in the two measures of inflation is leading to differences in policymakers over which inflation RBI should target. India’s growth has also slowed suddenly in Q2 at 5.4 percent against consensus expectations of 6.5 percent. A slowing growth is putting even more pressure on RBI to lower interest rates.

Dissenting voices from the government side

The Economic Survey 2023-24 raised this debate in July 2024 arguing that RBI should leave food inflation and instead target core inflation. The Commerce Minister Piyush Goyal also echoed similar comments recently. RBI’s Monetary Policy Committee (MPC) on the other hand is steadfast in its approach and not changing its policy stance due to elevated headline inflation. There have been cases of MPC members voting for lower policy rates but the consensus of “no change” has remained.

Unlike the government, RBI also has a longer-term perspective. If we trace evolution of headline and core inflation since formation of MPC in October 2016 we get some interesting facts. Of the total 97 monthly inflation data points, core inflation has been higher than headline inflation in 53 months compared to 44 months on which headline is more than core. Even more interesting is that in these 53 months, core inflation is even higher than inflation target of 4%. So, it is not as if core inflation will always mean lower interest rates.

Central banks never discount the role of monetary factors

RBI like most other central banks also believe in the old age dictum that “inflation is always and everywhere a monetary phenomenon”. Hence, even if there are food shocks which are driving headline inflation, RBI thinks monetary factors play an important role too.

The nature of debate is interesting for another reason. Ideally, RBI would be happier to target core inflation as it keeps away the pressure of looking at food and fuel shocks from its monetary policy. But RBI is defending its targeting headline inflation as it captures the overall inflation position in the economy. The weight of food and fuel is also 50 percent plus which means if one targets core inflation, you are leaving out half of the basket making the whole exercise meaningless.

In case of government, it should be happier that RBI targets headline inflation. Elections have been lost in the past due to high food inflation. A higher headline implies RBI not changing its monetary policy which puts pressure on government to improve food supplies and lower food inflation. Targeting core would mean food inflation is no one’s responsibility which will eventually be a disaster for the government.

To sum up, the old debate of headline vs core inflation is back in India’s political economy. While MPC members will discuss the divergence, it is unlikely they will be pressurized to lower interest rates. After all, one major objective of constituting a MPC was that it will work independently and not be pressurized by the government. Instead of getting into this futile debate, the government should work towards updating the base-year of CPI which has remained unchanged since 2011-12. The change of base year will automatically lower the weight of food in the basket and help RBI in its monetary policy.