Should rate-setting panel track headline or core inflation? RBI stirs debate

Mint

9 hours ago

The central bank has initiated a process to gather opinions on whether monetary policy should track headline inflation or core inflation, which strips out the impact of fuel and energy price increases.
The Reserve Bank of India (RBI) on Thursday released a discussion paper on its inflation-targeting framework seven months before the existing one comes up for renewal. The framework is reviewed every five years, with the last one happening in 2021, when the government, in consultation with RBI, set it at 4% with a tolerance band of +/-2%.
The discussion paper asks four questions. First, whether headline inflation or core inflation would best guide the conduct of monetary policy, given evolving relative dynamics of food and core inflation and the continuing high weight of food in the consumer price basket. Second, whether the 4% inflation target continues to remain optimal for balancing growth with stability in a fast-growing, large emerging economy like India.
Third, should the tolerance band around the target be revised in any way, including whether it should be narrowed, widened, or eliminated? Lastly, should the target inflation level be removed, and only a range be maintained within the overall ambit of maintaining flexibility without undermining monetary policy's credibility?
The debate over whether core inflation should be the benchmark instead of the headline numbers has been ongoing for some time.
It centres around monetary policy's handicap on food prices as they are caused by supply-side problems like food supply issues and not by demand, which can be controlled by interest rate changes. Food currently occupies a 46% weight in the headline consumer price index or CPI basket.
In July 2024, the Economic Survey for 2023-24 suggested excluding food prices from India's inflation-targeting framework
'The debate on what should be the monetary policy target benchmark–headline inflation or core inflation (which excludes the volatile components of inflation, such as food and fuel from headline)–is premised on the issue of inclusivity vs stability," the discussion paper said.
It said that headline inflation is favoured worldwide as a more representative measure of the overall price conditions. In fact, except for Uganda, all nations that target inflation look at headline inflation.
The paper said the argument for targeting headline inflation emphasises that downplaying the role of food inflation in price stability can erode monetary policy credibility and de-anchor inflation expectations.
According to the paper, there is also the argument that the current CPI base (2011-12) is outdated, and the share of food would decline considerably once it is revised to a more recent year.
'However, the continued dominance of food in Indian households' consumption basket is corroborated by the latest Survey of Household Consumption Expenditure 2023-24. It indicates that 90% of the lowest fractile rural households and 50 per cent of the lowest fractile urban households spend more than 50% of their monthly consumption on food and energy," it said.
RBI said the quarterly path since inception of flexible inflation targeting showed that average inflation was at 3.9% during the first four years of the framework and very close to the target. It exceeded the target during 2020-2024 (and even went above the upper threshold level of 6%), driven by supply disruptions on account of the pandemic, geopolitical conflicts and adverse weather events, it said.
The paper said that while there are arguments on both sides as to whether to raise or lower the target of 4%, justifications for pursuing the target and the framework stem from India's relative success in lowering inflation and responding to exogenous shocks.
The discussion paper said that, like other countries, India may consider narrowing its current tolerance band to about 1-1.5%. Moreover, the recent consumer expenditure survey suggests that the share of food and beverages in the upcoming new CPI series could be lower, further lowering the volatility of headline inflation.