How to fight stubborn inflation

In today’s Finshots, we dive into some clever tricks that the RBI and the government could use to bring down inflation.

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That being said, let’s move on to today’s story.

The story

Rising prices are a part of life.

The other day I went to the market to buy fish. And after buying a kilo, my wallet was almost empty. I had no money left to buy vegetables. This is a pain we all feel.

But it’s not just a problem for you and me. It’s also a headache for the RBI and the government. Economists call it inflation. And while they try 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 what’s the solution, you ask?

Well, one idea floating around would be to simply take food out of the inflation equation.

Wait… what? This may sound crazy, we know. But it’s not a far-fetched theory. Serious analysts are studying this idea and even the latest economic study mentions it. And while it may seem absurd at first, hear us out.

Inflation has two main components.

First, there’s 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, that is, that which concerns food and fuel.

Put these two together and you get headline inflation, also known as the consumer price index (CPI).

For years, the RBI has been trying to control headline inflation. In 2016, the RBI and the government agreed to aim for an inflation target of 4%. The idea was to have a roadmap to keep price rises in check, with a tolerance of 2% above or below this target.

To achieve this goal, the RBI has been raising interest rates, especially since the pandemic. Raising rates makes borrowing more expensive, which encourages people and businesses to spend less. In theory, this lowers prices. And it has worked quite well. Inflation has fallen from 6.2% in 2021 to 5.4% in 2024.

But here’s the rub: despite all its efforts, the RBI can’t seem to hit its magic 4% target. The main culprit?

Food!

You see, inflation can happen in two ways.

First, there is demand-pull inflation. This occurs when there is a high demand for something and prices increase because people are willing to pay more. Take airline tickets, for example. The more people want to fly, the higher the prices go.

But there is also cost-push inflation, which occurs when prices rise due to external factors such as increased 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 them, but because of factors like erratic weather, heat waves, and supply chain disruptions. No matter how high prices go, people still need these essentials. It’s a supply problem, not a demand problem.

If we exclude fuel from the inflation equation, the RBI has done quite well. To put things in perspective, core inflation fell to 4.3% in FY2024, a four-year low. And this played a significant role in the decline in headline inflation, which was the lowest among emerging and developing economies (EMDEs).

But even though food prices have come down somewhat, the RBI still cannot cut interest rates to boost the economy. A rate cut would help businesses grow by giving them better access to capital. But the RBI has been holding rates steady for almost a year and a half now (since February 2023 to be precise).

The reason is that it cannot just say, “Hey, core inflation is under control, let’s start cutting rates.” If it does, people will have more money to spend, which could push prices up again, especially in an environment of already high food prices. And the RBI would be back to square one.

But that’s not all. Rising food prices also have repercussions in other areas. For example, when food becomes more expensive, households feel downward pressure and start asking for wage increases. And when employers increase wages, they have to earn more money to cover the costs, which pushes prices up again. It’s a vicious circle.

This is why some analysts suggest removing the feed-in from the inflation targeting framework altogether.

But wait, Finshots… Isn’t food a huge part of household spending? Haven’t you seen the latest Household Consumption Expenditure Survey? You better have, because you’re the one who said that rural households now spend about 46% of their money on food, and urban households nearly 40%. So how can anyone seriously suggest excluding food from the inflation targeting framework when it represents such a large part of our spending?

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

But here’s the problem. The CPI is calculated by taking into account household spending on nearly 300 different items and services, each with its own weighting based on its importance in the average household budget. And here’s the rub. The CPI basket includes obsolete items like horse-drawn carriage rides, VCRs, and audio and video cassettes. Who uses those items anymore? So, yes, the CPI basket is a bit obsolete.

The same is true for food. The weight assigned to food in the CPI has remained unchanged for over a decade, all because of the previous Household Consumption Expenditure Survey, conducted over a decade ago. At that time, rural households spent about 53% of their expenditure on food, and urban households, 43%. But these figures have since declined. Based on this data, the current weight of 46% in the CPI for food is therefore a bit exaggerated.

So, instead of eliminating food altogether, it might be wiser to simply update the weight it gets in the CPI calculation. And guess what? The government is already considering that option.

Will changing the weight of food in CPI actually help the RBI control inflation better? Or is it more sensible to remove food from the headline inflation framework?

We are not economists, but we know one thing: no matter what they do, our food prices will not magically shrink. Even the RBI governor is not convinced that it is wise to remove food from the equation altogether.

But at least by fixing the weights and the basket we could have a more realistic picture of inflation.

So far…

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