Anchoring expectations

Food prices are disrupting the disinflation process

Episodes of food- and fuel-price volatility are not unusual in India. Sustained food-price pressure continues to drive the headline inflation rate, making it important to understand how such price shocks can get in the way of managing inflation outcomes. While inflation outcomes have become relatively favourable, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) expects the inflation rate to average 4.5 per cent this financial year, but that will still be above the 4 per cent target. Even though the core inflation rate has softened to below 4 per cent in response to monetary tightening and correction in input costs, the repetitive incidence of food-price pressures has deterred the headline inflation rate from converging to the core. Despite a decline from 5.7 per cent in December, the headline-inflation rate remained at 5.1 per cent during January-February 2024. Further, after correcting in January, the food inflation rate edged up to 7.8 per cent in February, primarily driven by prices of vegetables, eggs, meat, and fish.

From a monetary policy perspective, it is essential to understand how such price pressures from food or fuel can affect overall inflation outcomes. A new research article by economists at the RBI examines the second-round effects of food and fuel prices on headline and core inflation in India. While the headline and food-inflation rates move in tandem with a high correlation, there is also evidence of a high correlation between household inflation expectations and food inflation. This has implications for the behaviour of the core inflation rate, which is significantly determined by household inflation expectations.

RBI economists also found evidence of convergence of core with headline inflation for the near term, indicating the transmission of shocks from non-core components to core inflation. From a high of 0.37 percentage point during the late 1990s, the response of the core-inflation rate to a 1 per cent rise in the food-inflation rate has been decreasing more or less consistently ever since then. As of the third quarter of 2023-24, the response was at 0.14 percentage point. Moreover, the impact of fuel-price shocks on core inflation is found to be largely insignificant, though such shocks persist for a longer duration. The recent decline in volatility in core inflation rates, specifically after the adoption of the flexible inflation-targeting framework in 2016, has been significant for monetary policy, implying better anchoring of inflation expectations.

Yet, concerns remain. The high weighting of food and fuel items in the underlying consumer basket can strengthen the propagation of shocks to core inflation. The recent firming up of international crude oil prices also warrants close monitoring. Low reservoir levels, especially in the southern states, and the outlook of above-normal temperatures pose concerns in the short term. However, the above-average monsoon rainfall should bring some relief in terms of boosting agricultural output. Nonetheless, food-price uncertainties in the future, driven by the increasing incidence of climate shocks, would continue to weigh on the inflation outlook. Food-price volatility is becoming increasingly hard to predict, particularly in the face of rising extreme weather events. Frequent shocks might demand tighter monetary policy over time. The commitment of the MPC to attain the inflation target of 4 per cent on a durable basis should help anchor expectations and reduce volatility in inflation outcomes.