Dealing with cost-push inflation

The Reserve Bank of India (RBI) does not have a policy tool to deal with one kind of inflation, viz. cost-push inflation. However, it is often not realised that the government does have such a policy tool. Before I explain this “out-of-the-box” solution, let me put the issue in context.

In 2016, the RBI was formally given the mandate till March 31, 2021, to target 4 per cent inflation with a leeway of plus/minus 2 percentage points. Now the specific targets are under review. What should we do?

The leeway of 2 per cent on a base target of 4 per cent is actually a “flexibility” of 50 per cent! This is huge. It affects purchasing power of the public. It also affects financial stability, given the relationship in practice between inflation, nominal interest rates, and asset prices. So, there is a rationale for reducing the leeway. But is that possible?

At present, an important reason for the large leeway around the inflation target lies in the behaviour of the prices of oil and food, which can push prices more generally. What can the government do about this cost-push inflation?

On oil price, the policy suggestion here is simple. Given the average tax rate on oil that the government wants to impose, the tax needs to be variable and countercyclical, which means that it should be low when the international oil price is high and it should be relatively high when the international price is low. The policy suggested here stabilises the path of the domestic oil price. There is then hardly any issue of significant cost-push inflation or disinflation related to the price of oil!

In the last several months, the government has had a serious revenue shortfall, which is why the tax on oil has been increased even when the international oil price was going up. This is a very soft option; there are other meaningful and practical ways to raise resources. But that is a different story.

Let us now come to the price of food. The price for the consumer includes taxes imposed by the government. As in the case of oil, these taxes need to be countercyclical. It is true that the tax rate on food is not very high compared to the tax rate on oil. But there is enough room for policymakers to stabilise the price of food. It is also true that the tax on food is now part of the goods and services tax (GST). However, that is not a serious obstacle.

What is being suggested here is only a predictable variation in specific tax rates over a cycle; the suggestion is not to make the taxation policy arbitrary.

Another policy that can be useful in stabilising the price of food is liberalisation of international trade in food items; we can have a shock absorber there too in keeping the path of food prices stable in the country. Yet another policy is related to the minimum support price (MSP) for agricultural output. Over time, the level of MSP has become a political economy issue. However, the basic and original idea behind what has come to be called MSP was to avoid the unbearable large fluctuations in market prices. This remains a good idea. It helps not just producers but also consumers of food. Relatedly, the cost-push inflation or disinflation due to sharp changes in the price of food can be minimised. So, we have a case here for putting in place adequate infrastructure to make the original idea of the MSP meaningful in more states and for more crops.

As we know, under the prevailing policy regime, we can have significant cost-push inflation. Given such inflation, the demand for money and credit goes up in the economy. Then, the RBI is under pressure to expand base money, otherwise real economic activity can suffer. This expansion of money then actually sustains the inflation that originates elsewhere. It is interesting that all this is by and large avoided under the policy regime proposed here.

Section 4 of the 2020-21 RBI Report on Currency and Finance gives detailed reasons for retaining the large leeway around the inflation target. However, it has missed the elephant in the room, which is the role of the government in this specific matter! If it had not, it may have recommended a relatively smaller leeway of, say, 1 percentage point around the 4 per cent inflation target, which still implies 25 per cent flexibility. This is needed because even under inflation targeting, often the RBI has to look after other variables like aggregate output and exchange rate.

Many commentators opine that inflation targeting has worked well over the last five years. Why change then? It is simple; we can make it much better. 

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre