The US Federal Reserve and many other central banks target ‘core’, rather than headline, inflation, excluding the impact of food and energy prices to arrive at that core measure. The logic is that food and energy prices are ‘supply-driven’ and, hence, less amenable to being controlled via monetary policy, which primarily impacts aggregate demand.
India’s core CPI inflation has been well below 4% since December 2023. So, if RBI was focusing on core inflation, it would have been obliged to cut its policy repo by early 2024. However, food prices are crucial to the typical Indian householder’s well-being and, hence, cannot be ignored by the RBI. It is sensible, therefore, for it to target headline rather than core inflation.
The US Federal Reserve cut its policy rate by half-a-percentage point last month, despite the fact that inflation as measured by its preferred gauge of core PCE (personal consumption expenditure) was still well above its 2% target at 2.6% in July and 2.7% y-o-y in August 2024.
Monetary policy is expected to be forward-looking. As long as the trajectory of inflation is likely to be taking it towards its target, monetary policy usually adjusts in anticipation of that happening. RBI has been extremely wary of the volatility of food inflation, particularly vegetable prices, which spurted sharply upward in July 2023 and again in June 2024. Vegetable inflation was 37% y-o-y in July 2023, and 29% in June 2024.Although vegetables have a weight of just 6% in the CPI basket, these sudden spurts in vegetable inflation have raised headline inflation sufficiently on both occasions, obliging RBI to postpone plans to reduce restrictiveness of its monetary stance, particularly after the June 2024 spike.But vegetable prices declined in August – although they were still more than 10% higher than a year earlier – and appear to have moderated further in September. With food inflation abating, headline inflation was at a 5-yr low of 3.6% in July and 3.65% y-o-y in August. Five years ago, when inflation was slightly higher (3.99% in September 2019), repo rate was cut by 25 bps to 5.15%.
Yet, recent statements by Shaktikanta Das hint that the repo rate will remain unchanged at 6.5% today. This would be illogical, given that CPI inflation is now at the lower half of RBI’s 2-6% target, and below the central bank’s stated near-term goal of not letting inflation exceed 4%.
With global inflationary pressures easing, the Fed, European Central Bank (ECB), and several other central banks including those of South Africa, Canada and Britain have lowered their policy rates in the past couple of months. One consequence of RBI not following the global trend would be a rapid surge in India’s forex reserves, which have risen by $35 bn in the last seven weeks to a record level of $705 billion on Sept 27.
Only China, Japan and Switzerland have more forex reserves. Persistence of higher interest rates in India while they decline elsewhere naturally will place some upward pressure on the rupee. To prevent rupee appreciation, RBI is choosing to allow forex reserves to rise rapidly.
Instead, with the growth momentum slowing (to less than 7% y-o-y in real GDP in the latest quarter, from 8.2% growth in FY24), and inflation below its stated target, it’s time for RBI to lower interest rates. The fragile recovery in private investment, in particular, requires real interest rates to be lower.
With this year’s monsoon having delivered 8% more rain than the long-period average, a bountiful kharif harvest is expected. This will further dampen food inflation from next month onwards.
The goal of ‘Viksit Bharat’ requires real GDP to be growing 8% or more annually over the next few decades. An over-conservative approach to monetary management should not become an unnecessary obstacle on the path to sustainably faster economic growth.