Decoding the inflation debate

The Reserve Bank of India (RBI) has been following a flexible inflation targeting (FIT) approach since its monetary policy framework agreement (MPFA) with the Government of India in February 2015.

- ASHOK KUMAR LAHIRI

The year-on-year inflation target of 4 per cent, with a tolerance band of 2 to 6 per cent, was announced in the Gazette on August 5, 2016. The new Section 45ZA in the amended RBI Act requires the government, in consultation with the RBI, to determine the inflation target in terms of the consumer price index (CPI) once every five years.

After the first quinquennial review, the validity of the target of 4 (±2) per cent was extended beyond March 31, 2021 to March 2026. Another review is due before March 2026. Two issues that have cropped up in this context are: (i) should the target be "core" rather than "headline" inflation, and (ii) should the target be revised upwards?

On the first tricky issue: Imagine yourself dissuading your spouse from buying tomatoes or carrots because of their high prices. The well-informed spouse asks you to stop the nonsense and shut up. They cite the "core" inflation figure and how the RBI has declared victory over price rise!

Shifting from headline to core inflation will give the impression of an attempt to downplay the importance of food items and energy prices in the cost of living, and to lower the bar on the definition of price stability. If the old weight of food items in CPI is out of sync with the current family budget with higher incomes, the weight should be reduced appropriately, without making it zero. Furthermore, even the superiority of core over headline inflation in predicting future inflation lacks sufficient empirical evidence.