His argument was simple but compelling: monetary policy cannot solve supply-side problems. It is designed to address short-term problems with aggregate demand. Yet food prices in India are a response to various rigidities in the economy, all of which are related to the supply side. Grain prices depend on how much the government has to pay farmers. Supply chains for vegetables and proteins are fragmented, leading to wild price fluctuations in response to temporary problems in availability and transportation. The chief economist’s argument is therefore quite understandable.
The cost of ignoring his argument is high. Because the RBI targets an inflation index that includes volatile food prices, it consistently keeps rates higher for longer than necessary. Core inflation – excluding food and fuel – has been well below the 4 percent mark for some time. But the central bank has not cut rates because Indian food prices are higher than those of other countries. In recent weeks, food inflation has fallen not thanks to a change in policy or demand, but simply because a summer heatwave has subsided. Still, we will probably have to wait a few more months for the central bank to react. The RBI’s rate panel has now met nine times in a row without a cut. Every week that an economy has to endure a higher-than-necessary real interest rate without investable funds can be measured in lost profits, growth and jobs.
The argument against a change is just as simple: as long as food prices affect Indians’ inflation expectations, they cannot be excluded from the RBI’s calculations. This is precisely what the central bank governor insisted on last week. He fears that the RBI’s credibility depends on whether it responds to the general price level and not just core inflation. This too is true.
But the governor also made a fatal mistake. He thought that India’s consumer price index, and hence its mandate, gave adequate weight to food prices. In fact, based on surveys from 2011-12, the index gives too much weight to food prices, which make up 45 percent of the basket of goods. Like agricultural policy, its composition reflects the idea that India is little more than a subsistence economy. With each passing year, this view becomes more outdated.
India’s consumer price index does indeed need to be restructured, and urgently. Many of the emerging economies that also target inflation are doing better than we are. Take Indonesia, for example. It has similar problems with volatile food prices, but food also has a much lower weight in the country’s consumer price index. And, more importantly, that weight is constantly being adjusted to reflect reality. Every few years, statisticians examine actual household consumption in hundreds of cities and reweight the index accordingly. That is certainly not too much to ask of their counterparts in New Delhi and Mumbai.
If we don’t do that, India will continue to have a central bank that guides its monetary policy on a price index over which it has half no control. Is it any wonder that the RBI is constantly lagging behind?
