How to fight stubborn inflation

In today's Finshots, we look at some clever tricks that the RBI and the government could use to bring down inflation.

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The story

Price increases are part of life.

The other day I went to the market to buy fish. And after buying a kilo, my wallet was practically empty. No money left for vegetables. It's a sting we all feel.

But it's not just a problem for you and me. It's also a nuisance for the RBI and the government. Economists call it inflation. And while they're trying to make it more bearable for us, they're kind of stuck. They just can't seem to control it as well as they'd like.

So you're wondering what the solution is?

One of the most common ideas is to simply remove food from the inflation equation.

Wait a minute… what? We know that sounds crazy. But it's not a wild theory. Serious analysts are considering the idea, and even the latest economic survey mentions it. And while it may seem nonsensical at first glance, hear us out.

Inflation has two main components.

First, there is core inflation, which covers things like education, clothing, rent, healthcare, transportation, and other household expenses. Notice anything missing?

Yes, food and fuel are not included here.

The second part is non-core inflation, which concerns food and fuel.

When you add these two values ​​together, you get the overall inflation, also known as the Consumer Price Index (CPI).

For years, the RBI has been trying to get a grip on headline inflation. Back in 2016, the RBI and the government agreed to target an inflation rate of 4%. The idea was to have a roadmap to keep price rises under control, with a tolerance range of 2% above or below this target.

And to achieve this goal, the RBI has been raising interest rates, especially since the pandemic. By raising interest rates, loans become more expensive, so people and businesses spend less. In theory, this cools prices. And it somehow worked. Inflation fell from 6.2% in FY21 to 5.4% in FY24.

But here's the catch. Despite all its efforts, the RBI just can't seem to hit the magic 4% target. The main culprit?

Eat!

Inflation can arise in two ways.

First, there is demand-led inflation. This is when there is a lot of demand for something and prices rise because people are willing to pay more. Think of airline tickets. The more people want to fly, the more prices rise.

But then there is cost inflation. This occurs when prices rise due to external factors such as higher labor or transportation costs.

And that's exactly what's happening with food prices. Even staples like onions, tomatoes and potatoes are getting more expensive, not because people are suddenly eating more of those foods, but because of erratic weather, heatwaves and supply chain disruptions. No matter how high prices go, people still need those staples. It's a supply problem, not a demand problem.

Now, if you take food out of the inflation equation, the RBI has actually done pretty well. To put things in perspective, core inflation has fallen to 4.3% in FY2024, a four-year low. And that has played a big role in bringing down headline inflation, which has been the lowest among emerging and developing economies.

But even though food prices have calmed down somewhat, the RBI is still unable to cut interest rates to stimulate the economy. A rate cut would help companies expand by giving them better access to capital. But the RBI has been keeping interest rates stable for almost a year and a half now (since February 2023, to be precise).

Because the central bank can't just say, “Hey, core inflation is under control, so let's start cutting rates.” If it does that, people will have more money to spend, which could push prices back up, especially with food prices already high. And the RBI would be back to square one.

But that's not all. Rising food prices have an impact on other things too. When food becomes more expensive, households feel the pressure and demand wage increases. And when employers increase wages, they have to earn more money to cover costs, which drives prices up again. It's a vicious circle.

For this reason, some analysts suggest excluding food from inflation targeting altogether.

But wait a minute, Finshots… doesn't food account for a large part of household expenditure? Haven't you seen the latest Household Consumption Expenditure Survey? You better have, because it was you who said that rural households now spend about 46% of their money on food and urban households almost 40%. So how can anyone seriously propose removing food from the inflation targeting framework when it accounts for such a large part of our expenditure?

Actually, you're right. And we had the same thought.

But here's the thing. The Consumer Price Index (CPI) is calculated by looking at how much households spend on nearly 300 different items and services, each with its own weight depending on how important it is in the average household's budget. And here's the kicker. The CPI basket includes outdated things like horse-drawn carriage fares, VCR prices, and audio and video cassette costs. I mean, who uses that anymore? So, yes, the CPI basket is a bit outdated.

The same is true for food. The weighting given to food in the CPI has remained unchanged for over a decade, thanks to the Household Consumption Expenditure Survey conducted over a decade ago. Back then, rural households spent almost 53% of their expenditure on food, while urban households spent 43%. But these figures have since fallen. On this basis, the current weighting of 46% given to food in the CPI is somewhat exaggerated.

For this reason, rather than eliminating food items altogether, it might make more sense to simply update the weight assigned to them in the calculation of the consumer price index. And guess what? The government is already thinking about it.

Will adjusting the food component of the CPI really help the RBI to better control inflation? Or is it wiser to remove food from the inflation framework?

We are not economists, but one thing we do know is that whatever they do, our food will not magically become cheaper. Even the RBI chief himself is not convinced that it is wise to remove food from the equation altogether.

But at least setting the weights and the basket could give us a more realistic picture of inflation.

Until then…

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