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Inflation targeting: Surge in prices of onion & sugar has brought back bad memories

A surge in prices of onion and sugar has brought back the bad memories of farm economy roiling the rest.

, ET Bureau|
Updated: Dec 11, 2019, 08.44 AM IST
The share of food in headline CPI in India at 45.9% is much higher than the 10-20% in other countries.
When scores of Ivy League-trained economists are burning midnight oil with their sophisticated forecasting models to figure out what the Reserve Bank of India would do next on interest rates, Bank of America has a simple suggestion — just keep a watch on onion prices.

The mostly ubiquitous and affordable onion that is part and parcel of any Indian cuisine, last week threw many calculations to wind as the mighty central bank had to bow to pressure from the soaring prices of the essential vegetable rather than do its might to revive an economy where growth rate has fallen to a six-year low.

A Monetary Policy Committee mandated to maintain inflation at 4% with a two percentage point band on either side — a new adoption of Western model to Indian policy making — is grappling with the same old problem: food prices.

Prudent policy making to stabilise prices and the expectations of price rise and a need for a pragmatic regime to fuel investments have come into conflict once again as the basic structure of Indian economy remains at the crossroads.

“The monetary authority is helpless in handling a supply shock-induced inflation till it feeds into a generalised inflationary expectations,” says Partha Ray, professor of economics at IIM Calcutta. “This issue is all the more important in India in the current context when onion prices are skyrocketing.”

The RBI last week shocked markets when it kept the repo rate — the rate at which it lends to banks — untouched at 5.15% citing price pressures, especially food items such as onion, milk, pulses and sugar. Investors were expecting the central bank to supplement government measures by further lowering the benchmark rate by a quarter point as the central bank and the government were appearing to be in sync with their prescription for an economic revival.

“Inflation has indeed risen sharply in November and may remain elevated for a few months,” Governor Shaktikanta Das said justifying the pause. “However, the forces driving up inflation appear to be transient.”

Still the six-member MPC wouldn’t cut rates. Why? Because the onion and cereals prices have driven inflation expectations by more than 100 points! It’s yet again the ‘transient’ inflation that’s impacting expectations, which the 2016 ‘inflation targeting’ policy aimed to address.

The share of food in headline CPI in India at 45.9% is much higher than the 10-20% in other countries.

“If we compare India’s CPI weightages to that of its BRICS peers, the disparities become starker. While India’s food basket has been allocated nearly 39%, the category’s share is only 25.5% and 19.1% in Brazil and South Africa, respectively,” said a research paper by Sidbi-promoted ratings firm, Acuite Ratings and Research, earlier in 2019.

Items such as housing, amusement/ recreational expenses, consumer durables, FMCG and transportation have gained in prominence over time but continue to represent a lower weightage in the overall price index.

“The Reserve Bank has no jurisdiction over the construction and composition of CPI, though the restructuring by the government is underway,” said Tirthankar Patnaik, chief economist at the National Stock Exchange. “We cannot ignore the fact that Indians still spend a big portion of their income on food and RBI has to anchor inflation expectations of the Indian household given the way food inflation has risen.”

October consumer prices rose 4.68%, highest in 18 months, which few saw two months back.

The MPC in its August meeting had forecast inflation for the second half at 3.5-3.7%, which was retained in October and come December, it goes to 5.7-4.1%. In all, 40-220-basis points revision in a matter of four months.

Then, there is perhaps a case of revisiting food weightage in the consumption, given its impact on RBI’s inflation target, which, in turn, has a big role in determining the rate at which funds for investments are available. Or whether food should be completely eliminated by the RBI while arriving at inflation forecast given that food inflation in India still continues to be due to supply-side factors and vagaries of monsoon?


Blaming the rate action completely on food prices may be missing the woods for the trees.

“If the MPC is being influenced by the prices of food, then it is an MPC issue,” says Jahangir Aziz, economist at JPMorgan. “The MPC could easily ignore food inflation on the grounds that it is temporary as it did in the last review: after rising in the first half, inflation falls below the 4% target in second half in the MPC’s own forecast. The fact that the MPC thought that it was appropriate to keep policy rate on hold despite their own forecast that inflation would slip below the target 9 months ahead, is an issue about monetary policy making. It has nothing to do with the weight of food in the CPI basket.”


When a central bank is mandated by law to maintain price stability, the key to achieve this is the ability to forecast where the prices would be, a task more complicated than weather forecasting.

Most countries adopt targeting wholesale prices, which is a right reflection of the state of an economy. India chose to target Consumer Price Index with a substantial portion of spending going on food. Predicting industrial products prices is a lot more easier than food prices.

A research paper posted by the RBI staff on its website in May earlier this year notes that an examination of the CPI inflation projections in India during April 2015-September 2018 show two periods of large projection errors — October 2016-March 2017 and June-September 2018.

“Both episodes were associated with unanticipated sharp fall in food inflation particularly in case of perishables,” the paper said. “Volatility in vegetables prices translated almost one-on-one to overall food inflation, given the magnitude of price variations and large weight of vegetables in CPI.”

This time, it is a reversal of the situation, with projection errors on the upside, with actual inflation overshooting the projection since July-August. Food prices rose 7.89% in October, from 5.11% in September, the largest annual gain since July 2016. Food & beverages index went up by 6.93%, with main upward pressure coming from vegetables at 26.10% as onion and tomato prices jumped due to unseasonal rains and disruption of supply chain.

Governor Das admits that challenges still remain.

“With regard to growth and inflation, all that we want to say is that we have certain projections, based on the available data,” Das said. “We feel that we need some more time to have greater clarity and less uncertainty about our projections. We just want to be convinced that whatever projections we have made at this point of time with regard to inflation and with regard to growth, the coming months will play out on the same line. So, there is need for greater clarity, there is need to be more certain about it, to reduce the element of uncertainty in our projections.”

Administrations the world over prioritise tackling prices as any failure on that front could lead to social chaos as well as regime fall. This puts policy makers in a quandary as containing price pressures often militate against the interests of industry, which is expecting the next interest rate cut.

That was probably one of the reasons that the Prime Minister Narendra Modi government chose targeting consumer prices rather than wholesale prices. If vegetable prices are the ones that would determine, what’s in store on the rate front?

“Onion prices have now jumped up 371% year-on-year in early December from 177% in November,” says Indranil Sen Gupta, economist at Bank of America. “If they retreat to ?60/kg in December and ?40/kg in January from ?91/kg now, on government imports, inflation should peak off at 5.9% in December and slip to 5.4% in January. If onion prices moderate to ?60/kg only in January, when the bulk of onion imports arrive, inflation will still post 6.1% in January.”

That essentially means that there’s little scope for RBI to forecast inflation of about 4% anytime before April. The pause could extend to as long as October if crude oil prices join rising vegetable prices.

But if farm products affect policy making, is it time to rethink the gauge to target? Should it be WPI or CPI, or something else?

“There is no connection between the weight of food in CPI and food inflation,” says Aziz of JPMorgan. “The weight is the average amount a person spends on food relative to other expenditures. That is in the case of India and many other countries fixed at a particular base year and revised periodically. Some of the more advanced countries have shifted to both chain weighted CPI (and GDP) that takes into account substitution that consumers might undertake in reaction to changes in prices and is, therefore, closer to a better cost of living index.”

It is not clear by when India would move to a different model like that of chain weighted consumer price index, but till such time the current one would continue to determine policy rates.

“We advise investors to track onion prices as they hold the key to the next RBI rate cut,” says Sen Gupta of Bank of America.

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