Debate over excluding food inflation from monetary policy reaches MPC

Mumbai: Two newly appointed Monetary Policy Committee (MPC) members have rekindled the discussion started by the Economic Survey on excluding food inflation from the monetary policy framework.

Of the three external members of the rate-setting panel of the Reserve Bank of India, Nagesh Kumar and Ram Singh have argued in the MPC minutes released last week that a high repo rate cannot bring down food prices. The latest GDP growth rate of 5.4% and a spike in food inflation to 6.2% in October seem to have unsettled the MPC’s external members, who expressed views that sharply deviate from the August meeting's minutes.

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“During the last ten years, changes in repo rates seem to have made little difference to vegetable price volatility. Specifically, the elevated interest rates during the last ten quarters had no significant effect on price volatility, especially of TOP (tomato, onion and potato) vegetables, the primary source of volatility in headline inflation," noted Singh in the minutes.

Singh also suggested that the MPC should aim to bring CPI inflation within a range rather than aiming to bring it to a point target of 4%. Under the current framework, the RBI has been mandated by the government to maintain retail inflation at 4% with a margin of 2% on either side.

Unjustifiably high costs

"The costs of trying to shoot at the point target in every state of the uncertainty ridden future can be unjustifiably high," Singh added.

Commenting that the difference between the core inflation (<4%) and the policy rate (at 6.5 %) has been more than 2.5% for over a year now, Singh said "this makes for a restrictive monetary regime".

The other MPC member Nagesh Kumar too noted that, "Monetary policy, being a demand management tool, has limitations in addressing inflation largely driven by a supply-side shock driving up vegetable prices. The high vegetable prices represent an essentially seasonal supply-demand mismatch that has started to correct itself in November 2024," he said.

Are the new MPC members hinting at amending the flexible inflation targeting (FIT) framework?

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To be sure, changes in the FIT framework are possible only through legislative amendments, which the government can initiate in consultation with the RBI. FIT was adopted in June 2016 by the RBI to keep price volatility in check after Parliament amended the RBI Act to give the central bank an inflation-controlling mandate. Under the FIT regime, the finance ministry has set the target for Consumer Price Inflation (CPI) at 4%, with an approximation of ± 2%. The target is reviewed by the government every five years, with the next revision due in March 2026.

Following the adoption of FIT, consumer inflation fell to 3.9% on average in the three years from 2016 to 2019, from an average of 7.3% in the preceding four years prior to its implementation.

Persistently high inflation

Over the last five years, however, India has seen persistently high inflation. In all but two months this year, it has remained above the 4% target since October 2019. As required under the RBI Act, the MPC had to write to the government in 2022, explaining its failure to contain inflation under the upper tolerance limit of 6% for three consecutive quarters.

Former MPC members and experts, however, do not concur that the solution to the low growth-high food inflation challenge lies in amending the FIT, and advise that MPC cannot afford to ignore food inflation.

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"I do not see any mention of amendment of the act. In my view, interest rates anchor inflation expectations and prevent second round effects of food prices shocks," said Ashima Goyal, former MPC members & professor, IGIDR. “Also, to anchor inflation expectations we do not need high interest rates. As long as policy rates respond to persistent inflation and keep real rates near unity, it is adequate."

Former RBI deputy governor and member of the first MPC, Viral Acharya cautions about the cost of abandoning the FIT at this point of time. "It will be a signal to investors that the government/central bank is not happy with growth sacrifices required to keep inflation down. This will likely be viewed as an erosion of policy certainty and central bank credibility with long-term implications for inflation risk premium in the bond and currency markets," said Acharya.

Watch shocks' persistence

"The MPC should watch if supply-side shocks are persistent or generalizing into broader inflation, depending on which it can deliver what it wants without requiring that the Act be changed, he said. “There is flexibility within the act's framework."

According to former RBI governor D Subbarao, food cannot be ignored by monetary policy as it shapes inflation expectations of households.

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"For RBI to target an esoteric variable [core inflation] that is unconnected with people's everyday lives would raise the risk of RBI and MPC losing credibility. There is an argument that monetary policy acts on the demand side. Food demand is inelastic. Therefore, monetary policy is ineffective in managing food inflation. That is an acceptable argument if food inflation is a one-off. That is not an acceptable argument if food inflation is a trend, as it has become now," said Subbarao in an interview to Mint on the sidelines of Neemrana Conference organized by ICRIER. "It is clear that private investment has not taken off because of reasons beyond interest rates. There are other factors which are limiting private investment."

Discretionary approach needed

According to Abheek Barua, former economist at HDFC Bank, “I'd say there should be a more discretionary approach to handling inflation, especially when it impinges on growth. So we need to look at food, with some amount of discretion. Inflation expectations need to be anchored. What these MPC members are saying implicitly is that if you cannot handle supply-side shocks, you cannot get a handle on inflation expectation by this mechanical approach."

It was in the Economic Survey of 2023-24 that the government first noted that the inflation-targeting framework should be limited to controlling core inflation, which is CPI inflation excluding food. "Higher food prices are, more often, not demand-induced but supply-induced," it said. “Short-run monetary policy tools are meant to counteract price pressures arising out of excess aggregate demand growth."

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A little after the survey's observations came out, Union minister Piyush Goyal had said that use of interest rates for controlling food inflation was a "flawed theory".

RBI has, however, been steadfast in its defence of the inflation-targeting framework, highlighting benefits from retaining food prices within the central bank's inflation target. In the August policy minutes, the then RBI governor Shaktikanta Das said, “Its credibility needs to be preserved and sustained."