Political economy of relative inflation

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Since 2016, the Reserve Bank of India has followed a Flexible Inflation Targeting (FIT) framework with a mandate to keep inflation at 4% with an allowable spread of 2% on either side. This target is due to be revised after March 2021. Meanwhile, Chief Economic Advisor Krishnamurthy Subramanian has raised questions about the appropriateness of targeting headline CPI inflation.

He said given the predominance of supply-side inflation in India, targeting core inflation would be more appropriate. It should be noted that targeting another inflation measure is not on the agenda for the next review of the FIT framework. However, the issue of targeting core inflation relative to headline inflation cannot be ignored. While the core component of inflation has consistently been between 4% and 6% over the past five years, developments in non-core inflation have guided trends in headline inflation.

From a data perspective alone, it was low non-core inflation that helped the RBI much more to keep inflation near or below 4%. The need to maintain low underlying inflation likely makes government more accountable – a key feature of the FIT framework. For a country like India, there is no doubt that headline inflation is a better measure of the true cost of living. Therefore, headline inflation is a top anchor when it comes to the RBI’s ultimate welfare goal.

The “scissors effect”

In addition to exogenous supply shocks, the development of core and non-core inflation could be associated with certain structural problems. It is reasonable to expect that core and non-core inflation will move in the same direction. After all, fuel is a raw material for most production processes, and food is a basic necessity. However, there are times when core and non-core inflation has moved in the opposite direction, known as the “scissor effect” (Chart 1).

The price of food or fuel drops sharply with no significant spillover into basic components. Core inflation is rising, while non-core inflation is falling. This is problematic because the food vendors, who represent over 50 percent of the population, are the losers.

Rising prices for other consumer goods are making their situation worse. Farmers adjust their expectations to low prices and adjust production for the next period accordingly. This results in unbalanced growth; inequalities are increasing; and the trickle-down argument doesn’t seem to work.

From January 2018 to June 2018, core inflation fell from 5.32% to 6.15%, but non-core inflation fell from 4.86% to 3.94% over the same period. Subsequently, food inflation fell to near zero levels due to oversupply. Weak demand in the aftermath of demonetization further lowered prices. Consumer spending on food declined, while spending on services increased. The change in consumption pattern and budget allocation caused inflation measures to diverge and a clear jaws effect was observed.

From its sub-zero level, food inflation rose sharply throughout 2019 due to supply constraints after an inadequate monsoon season and core inflation began to slow slowly. Between September and October 2019, core inflation exceeded core inflation. The case was further exacerbated during the Covid crisis. In March 2020, the foreclosure caused a surge in underlying inflation due to “panic” buying and limited supply.

At the same time, the price war within OPEC and the resulting oil glut has driven fuel prices down. At one point, oil futures for one month delivery were trading at negative prices. Later in the year, a good monsoon meant a bumper harvest. The easing of the lockdown has prevented food prices from rising. We’re about to see another episode of the scissors effect.

The seasonality of food prices and exogenous oil shocks generally correct over time. If so, should policymakers be concerned about the divergence between core and non-core inflation? Although this is only a short-term effect, it exposes the structural problems underlying the Indian agricultural sector. Low incomes force farmers to borrow, even for consumption. Agriculture requires an initial investment while returns are uncertain. It only takes one supply shock to send them into a vicious spiral of borrowing.

Buffer stock

The presence of a substantial excess buffer stock of cereals with the CFI highlights the problem of abundance. By January 2021, the buffer stock was expected to be 2.7 times greater than the requirements of government social protection schemes. It was after the food distribution that was made during the nationwide lockdown. This testifies to inefficient management of the food stock in the warehouses. It allows wholesalers to engage in practices such as hoarding, resulting in spikes in inflation. These supply shocks cause inflation to deviate from trend and reduce the effectiveness of monetary policy.

In order to control inflation, it is necessary to carry out structural reforms in the agricultural sector and to make the supply and distribution channels efficient. Perhaps this was the goal on the minds of policymakers when drafting the newly enacted agricultural laws. This would allow farmers to sell outside the ‘mandisAs part of APMCs, enter into forward contracts with agro-industries and large retailers to sell their products at predetermined prices in the future, among others.

While the expected benefits would help reduce the likelihood of supply shocks, farmers would have to bear the brunt of falling prices. Farmers fear that with this new system, the minimum support price will be phased out and they will be at the mercy of big buyers for pricing. The problem would be worse for small farmers with fragmented land holdings who have little or no bargaining power. They would get reduced prices for their products. Revenues would continue to decline unless volume growth is good enough to offset the potential decline in prices.

Changing agricultural laws in isolation is not the solution to structural problems in the agricultural sector. The benefits of an efficient supply chain must be shared with farmers. There should also be a control system for large retailers who would buy directly from producers. In addition, futures contracts are complex financial products. At a minimum, farmers need to be made aware of the complications and risks associated with these contracts so that they are not exploited.

Even more important is to create work opportunities in the non-agricultural sector to absorb disguised unemployment in the agricultural sector. With reduced shocks, inflation expectations would be more accurate, increasing market confidence in the RBI’s monetary policy. Coordination between fiscal and monetary policy measures is vital when the economy is in stagflation. Political economy issues must first be resolved in order to get growth back on track.

Rohan is an MBA student and Das is professor of economics and president of the Misra Center for Financial Markets and Economy, IIMA.


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