The right inflation target

The rise of the consumer price index- based inflation to 8.3 per cent in March, from 8 per cent for the preceding month, is disappointing on two counts. The inflation rate has gone up (even if not quite as sharply as the increase in the wholesale price index) even as industrial output and exports have contracted in recent months. This apparent resurgence of inflationary pressures amid a deepening growth slowdown is bad news, given the direct impact on incomes and purchasing power. No less significant is the second concern – namely, the likely Reserve Bank of India (RBI) response to the higher inflation. The fact that CPI inflation has risen again after declining from its November peak of 11.2 per cent virtually rules out any interest rate cuts by the RBI. Forecasts of a less than robust monsoon courtesy El Nino, increases the probability of a hawkish monetary policy stance.

Such a stance has the potential of causing conflict if there is a BJP government formed at the Centre — a prospect that is by no means certain, but seems increasingly likely. Such a government would make economic revival its top priority. Although the manifesto of the BJP is silent on monetary policy, some of its top leaders have openly questioned the rationale of controlling inflation by keeping interest rates high. They have a point. When current inflation is largely caused by supply-side factors – from weather-induced crop damage to longer-term issues of farm productivity and inadequate investment in agri infrastructure – how does a policy of choking demand help? If anything, it will only aggravate an already serious slowdown. The RBI hasn’t really been able to furnish a convincing reply to this point of view, also entertained by industry, apart from noting how high inflation is bad for growth. But then so are high interest rates.

The RBI needs to seriously reconsider the idea of inflation targeting based on the CPI. The reason for it is food, which has an almost 50 per cent weight in the index. The inflation rates derived from this index would, hence, mainly reflect supply-side factors not amenable to control using interest rate tools. Those are more effective against demand-side price pressures, better captured by WPI inflation for manufactured products. The fact that it is currently ruling at 3.2 per cent gives the true picture of inflation resulting from low investment and consumption demand. It is this inflation that deserves targeting in the present circumstances. CPI inflation, on the other hand, is unlikely to come down in the next one year. Will the RBI continue to hold interest rates high till then, even with the economy showing no signs of recovery? It is quite unlikely that the next government will be happy about this approach.

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