Rajiv Kumar & Geetima Krishna Das: Can inflation targeting drag India out of "slow-flation"?

The RBI, by focusing on consumer inflation, is introducing new uncertainties to the execution of monetary policy

Reserve Bank of India Governor Raghuram Rajan was quoted in the press on March 22 as saying inflation targeting has not yet been put in place in the country. Be that as it may, it is clear that the RBI is set on the path of implementing the recommendations of the Urjit Patel committee on inflation-targeting as the exclusive goal of monetary policy - and using headline retail inflation to do so. Recent trends in inflation, however, help us identify some likely hurdles in implementing this policy stance.

India's retail price inflation, indicated by the Consumer Price Index (CPI), softened again in February to 8.1 per cent year-over-year from 8.8 per cent in January. Retail inflation has come down by a whopping three percentage points in three months, from 11.2 per cent in November 2013 - almost entirely due to lower vegetable prices. The rate of increase of vegetable prices, which was 61 per cent y-o-y in November 2013, plummeted to 14 per cent in February 2014. In keeping with the decline in retail inflation, wholesale price inflation (WPI) also declined to below five per cent in February 2014, reaching this level after nine months.

However, it is worth noting that the core CPI (excluding food and fuel) eased only marginally to 7.9 per cent in February 14, demonstrating a stickiness around 8 per cent since July 2013. Core inflation, the real measure of inflationary pressures in the economy, has not declined in line with headline inflation, reflecting the continuing supply-demand imbalances that persist despite the economic slowdown.

It is generally assumed that in a slowing economy, declining demand results in actual output being smaller than the supply potential of the economy. This prompts producers to lower prices to stimulate demand resulting in lower core inflation. This raises the question of why core CPI inflation is so high and sticky when growth is at sub-five per cent for the last eight quarters? Could it be that continued tightening of monetary policy has not and may not produce the desired inflationary outcomes, unless perhaps growth grinds to a complete halt? The following facts may be worth considering.

First, as already argued by some economists, India's potential rate of growth of GDP might have actually come down in the last two years from around eight per cent to around five per cent due to poor governance and a sharp deterioration in investment sentiment. With the decline in rate of growth of potential output, the negative output gap is not as large as assumed. Consequently, the decline in core inflation has not materialised.

Second, the RBI's household inflation expectation surveys show that inflationary expectations have been running in double digits for the past several years. These are not only driven by elevated food prices, which are not part of core inflation, but also by sticky inflation in the services sector, which constitutes 64 per cent of the core CPI basket. Services sector inflationary pressures, persisting at seven per cent over the last eight months, have not softened in line with other prices, and do not seem to be responding to monetary tightening.

Third, a significant number of prices in the economy are administratively controlled, including the prices of inputs like food, diesel, petrol, electricity and railway fares, which affect prices of other transport services as well. Prices of major intermediate goods like steel, cement, fertilisers, etc., are also directly or indirectly administratively determined. These prices, where changes require administrative decisions that are open to political pressures, take much longer to respond to monetary policy measures.

Fourth, a closer look at the components of core CPI reveals that 'recreation' services inflation remained sticky in 2013-14, due to their inclusion, for the first time, in the service tax net. 'Transport' services inflation remained high, as government deregulated and raised fuel prices. Education and medical services sectors are also partly government controlled, which puts a floor to these prices. The housing index has also been extremely sticky around 10 per cent since June 2012. Housing is a different asset class, with investors holding on to assets for a longer time and resisting a decline in prices to achieve anticipated returns.

These four factors explain, though perhaps not exhaustively, the stickiness in core inflation. It will take more than sustained monetary tightening to repress demand to address inflationary pressures. Addressing supply-side constraints through structural reforms is critical for tackling the present phase of 'slowflation'. This will take persistent effort and time. So market expectations that a stable electoral outcome will somehow bring the economy out of slowflation are surely misplaced.

While it is necessary to anchor inflationary expectations to achieve sustainable growth in the medium term, monetary policy action may not suffice to lower core retail inflation and break inflationary expectations. The incoming government will have to bite the bullet and carry out necessary supply-side reforms: increase agricultural investment; immediately scrap the APMC act; improve the quality of fiscal consolidation; and move as many prices as possible out of administrative controls to improve the effective of monetary policies. Therefore, we expect the RBI to remain on hold in the next policy announcement and also wait for the right moves by the new government to address supply-side constraints that will weaken core retail inflation before considering any relaxation of monetary policy.

But the Patel Committee recommended targeting headline, and not core, retail inflation. This makes food prices - food comprises 49.7 per cent of the CPI basket - critical to meeting its inflation target. The recent trend of softening of food prices may not last. Unseasonal winter rains have damaged various crops that will prevent a sharp and early softening of both cereal and non-cereal food prices. This will be followed by a seasonal rise in vegetable prices over the summer months. The risks of higher food prices may have gone up with the higher probability of El Nino that will most likely result in a sub-normal monsoon in India. This will put pressure on food prices, resulting in the reversal of the declining trend in headline CPI. So, by focusing on headline CPI inflation, and given the weight of food products in the CPI basket, the RBI may be exposing itself to weather uncertainties. This might well introduce new uncertainties and risks to the execution of monetary policy and achieving macroeconomic stability.

The writers are at the Centre for Policy Research, New Delhi