The Hidden Costs of Ignoring Food Inflation: Why India's Economic Strategy Needs to be Assessed

The Economic Survey preceding this year's Union Budget proposes a measure with far-reaching implications for inflation control: excluding food prices from the inflation target set for the Reserve Bank of India (RBI). In technical terms, this would mean focusing on 'core' inflation rather than the current practice of targeting 'headline' inflation. To fully grasp the impact of such a shift, it is crucial to understand two key points: the recent trends in inflation in India and the current approach to inflation control.

Firstly, food price inflation has recently surged to historically high levels. As of June, food prices had increased by nearly 10% year-on-year. This trend has persisted since 2019, predating both the COVID-19 pandemic and the Ukraine war, indicating that domestic factors are driving these changes. Given that food accounts for a substantial portion of the consumer price index, overall inflation has also remained elevated.

The second aspect to consider is the RBI's role in inflation control. Since 2016, by legislative mandate, the RBI has been tasked with controlling inflation through interest rate adjustments, a strategy known as 'inflation targeting'. While this approach implies a degree of precision and control, the reality has been less certain. The RBI has missed its 4% inflation target every year for the past five years. Similar challenges have been faced by central banks in the UK and the US, where inflation recently spiked well above target levels, largely due to global food price fluctuations.

This raises two pertinent questions regarding the Economic Survey’s suggestion. Is removing food prices from the inflation target justified in terms of economic policy goals? And, would the RBI be more successful in controlling core inflation than it has been with headline inflation? The answer to both questions hinges on the fact that food constitutes nearly 50% of household expenditure in India—a figure significantly higher than in countries like the US, where it is less than 10%.

A high share of food in household spending is often a proxy for lower living standards and greater vulnerability to price increases. Ignoring food price fluctuations by excluding them from the inflation target would mean neglecting a critical issue for a large segment of the Indian population. Proponents of the proposal argue that food price changes are 'transitory', meaning any spikes are temporary and followed by declines. However, this has not been the case in India, where food price inflation has remained positive every year since 2011-12.

The proposal to focus solely on core inflation also raises doubts about the effectiveness of monetary policy in such a context. Over the past 13 years, core inflation in India has met the 4% target only once. Moreover, evidence suggests that increasing the RBI’s repo rate does not necessarily curb core inflation and may even contribute to rising prices. Higher interest rates reduce demand, potentially leading firms to increase prices to protect their profit margins in the face of reduced sales and higher borrowing costs. Additionally, food prices influence core inflation because they affect wages, which in turn influence the costs of production across the economy.

Given that food prices impact overall inflation, excluding them from the inflation target makes little practical sense. Moreover, monetary policy alone is insufficient for controlling inflation when the central bank has no influence over food prices. The persistence of this belief in central bank-led inflation control can be traced back to a global ideological shift following the collapse of the Soviet Union, which promoted market-driven production and left inflation management to central banks.

Since 1991, Indian policymakers, eager to emulate Western practices, have adopted strategies that may not be suitable for the country’s unique economic context. Excluding food price inflation from the inflation target is one such misguided approach. The rise in food prices is at the heart of India’s inflation issue, and removing it from official measures will not solve the problem. If food prices continue to rise as they have in recent years, the RBI will also struggle to control core inflation.

Effective inflation management in India requires a broader strategy that addresses supply-side constraints in agriculture to boost production and stabilize prices. Ignoring food inflation without a plan to manage it would leave India vulnerable to threats against its standard of living. The Economic Survey suggests mitigating the adverse effects of food price inflation through income transfers to households. However, if food prices outpace general inflation, these transfers would increasingly burden the national budget, reducing funds available for other public goods.

Ultimately, there is no substitute for comprehensive measures to control the prices of all goods, which remains the stated goal of economic policy.