Why the Economic Survey’s suggestion to target non-food inflation is misguided

By contrast, food inflation has roughly doubled over this period from 4.6% to 9.4%.

The Economic Survey, released on July 22nd, is an engaging read. It provides many novel data Tables and Boxes. The Chief Economic Adviser Dr V Anantha Nageswaran should be complimented for this Survey. Indeed, a long review of some of its themes is warranted.

This article analyzes one specific recommendation that it made – instead of targeting (headline) inflation as at present, India should consider targeting a subset of that i.e. non-food inflation. This subset is close to what is defined as core inflation in USA, i.e. inflation excluding fuel and food, which is their target. Since fuel is only 6.84% of our CPI basket, and retail fuel prices are less volatile in India than in USA due to offsetting changes in fuel taxes, non-food inflation is a suitable measure of core for India. It comprises 60.94% of the CPI now, with the remaining consumer food price index (CFPI) component 39.06%. The CEA’s recommendation has attracted a lot of attention, going by articles in the financial media.

Core inflation as a concept gained traction in the US in the 1970s. Following OPEC’s quadrupling of oil prices in 1973, the Bureau of Labour Statistics started reporting it and the Federal Reserve incorporated it into its Greenbook projections and decision making process.

To begin with, even for developed countries, one can reject the core inflation concept on various grounds. But that requires historical and statistical evidence and conceptual justifications and even robust, commonsensical arguments, provided elsewhere. Instead, let us examine recent developments. In the RBI’s Monetary Policy Committee, since early 2023, strong dissent has centred around the steady drop in non-food or core inflation, from 5.3% last June to 3% this June, and below the RBI’s 4% target since October 2023. By contrast, food inflation has roughly doubled over this period from 4.6% to 9.4%, although somewhat erratically, and headline inflation has inched up this June above 5%.

In Chapter 3,  the Economic Survey discusses various measures to contain food supply shocks, starting with governmental buffer stock management, which it does. Another option is export bans. When there is a global shortage or global demand is high,  bans do certainly lower domestic prices, and benefit consumers. Box III.2 (Pg 95) provides details of the dates of the bans and their removals for wheat, non-basmati varieties of rice, and other food items – notably onions. But banning exports create disincentives to produce more.

Recommendations to tackle this dilemma are spelt out later in a section titled: how do we let the markets function in the interests of the farmer? Its five recommendations are:

ONE: By not banning futures or options markets at the first sign of price spikes.

TWO: By involving export bans only under exceptional circumstances.

THREE: By re-examining the inflation targeting framework.

FOUR: Increasing the Total Net Irrigated Area.                                                     .

FIVE: Making farming consistent with climate considerations.

The first two suggestions are sensible. The fifth suggestion, which I endorse, is of overwhelming importance. The sixteen line paragraph about it warrants careful reading.

However, about the third, the Survey states that since food is a big chunk of the CPI in India, “When central banks target headline inflation, they effectively target food prices.  So when food prices rise, inflation targets come under threat. Therefore the central bank appeals to the government to bring down the increase in the price of food products. That prevents farmers from benefiting from the rise in the terms of trade in their favour. India’s inflation targeting should consider targeting inflation, excluding food.” (emphasis added. Pgs 169-170)

To begin with, the Economic Survey should not have made such generic statements: first, that central banks effectively target food prices, and second, that the central bank appeals to the government to bring down food prices. Decades before the RBI started inflation targeting, and even before its top brass became aware of the policy, which started in the early  1990s, the Indian government periodically imposed such bans, without appeals by the RBI.

While meant to help consumers, the export ban has badly backfired for onions. Following a quasi ban via a Minimum Export Price from October to December 2023, onions were placed under the Prohibited category upto 31 March 2024.  However, on 22 March the Government extended the ban indefinitely, then later rescinded it in May.

By then, the damage to onion farmers had been done, despite political gains from lower onion prices for consumers all across India.  The biggest wholesale onion market in Asia is Lasalgaon in Nashik district.  In the 2019 elections, the BJP’s alliance won 11 out of 13 seats in the onion belt of Maharashtra.  But last month it lost 12 out of 13 seats to the INDIA alliance, a stunning reversal. In Beed constituency, even Pankaja Munde, stalwart BJP leader, lost in her family bastion. (Verdict 2004, Shagun, downtoearth magazine, 5 June 2024)

The political tug of war between consumers and farmers will continue to play out. But to suggest targeting non-food inflation to avert any likely export bans is misguided. When food inflation is high and non-food inflation is low, cutting interest rates will initially raise food prices that respond faster to demand side increases. The political response to impose export bans will reduce incentives to produce, thus reducing farm productivity, thereby raising farm prices in the long run, and possibly headline inflation too.

Food supply shocks are a genuine problem. But in my opinion, they call for targeting headline inflation of a lower frequency -- say a three year average (RBI Should Specify its Inflation Metric, Indian Express, 2nd December 2014).