Political economy of relative inflation

Rohan Choraria/Abhiman Das | Updated on March 22, 2021

When non-core inflation falls but core inflation rises, it hurts farmers and exposes the structural faultlines in agriculture

Since 2016, the Reserve Bank of India has been following a flexible inflation targeting (FIT) framework with the mandate to keep inflation at 4 per cent with a permissible deviation of 2 per cent on either side. This target is up for review after March 2021. In the meantime, the Chief Economic Advisor, Krishnamurthy Subramanian, has raised questions about the appropriateness of targeting CPI headline inflation.

According to him, given the dominance of supply-side inflation in India, targeting core inflation would be more suitable. Note that targeting a different inflation measure is not on the agenda of the forthcoming review of the FIT framework. However, the issue of core versus headline inflation targeting cannot be ignored. While the core component of inflation has always been within 4-6 per cent over the last five years, the movement in non-core inflation has guided headline inflation trends.

Purely from a data perspective, it is the low non-core inflation which has aided the RBI much more to maintain inflation near or below 4 per cent. The need to maintain a low non-core inflation probably makes the government more accountable — a key feature of the FIT framework. For a country like India, there is no doubt that headline inflation is a better measure of the true cost of living. Hence, headline inflation is a superior anchor so far as the final welfare objective of the RBI is concerned.

The ‘Scissor Effect’

Besides exogenous supply shocks, the movement of core and non-core inflation could be associated with some structural problems. It is reasonable to expect that core and non-core inflation would move in the same direction. After all, fuel is a raw material for most production processes, and food is a basic necessity. However, there are times when core and non-core inflation have moved in the opposite direction, known as the ‘scissor effect’ (Chart 1).

The price of food or fuel witnesses a sharp fall without significant spilling over to the core components. Core inflation is on the rise, while non-core inflation falls. This is problematic because the sellers of food, which comprise more than 50 per cent of the population, lose out.

The rise in prices of other consumption goods exacerbates their predicament. Farmers adapt their expectations to the low prices and adjust next period production accordingly. This results in lopsided growth; inequality rises; and the trickle-down argument does not seem to work.

From January 2018 to June 2018, core inflation increased from 5.32 per cent to 6.15 per cent, but non-core inflation declined from 4.86 per cent to 3.94 per cent during the same period. Subsequently, food inflation reduced to near-zero levels owing to an excess supply. Low demand in the aftermath of demonetisation further subdued prices. Consumer spending on food decreased, while that on services increased. The shift in consumption pattern and budget allocation caused the inflation measures to diverge and a clear scissor effect was seen.

From its sub-zero level, food inflation rose sharply throughout 2019 due to supply constraints after an inadequate monsoon season and core inflation started softening slowly. During September-October 2019, the non-core inflation surpassed the core. The matter exacerbated manifold during the Covid crisis. In March 2020, the lockdown caused a spike in non-core inflation due to “panic” purchases and limited supply.

During the same time, the price war in the OPEC and the resultant glut in oil supply caused fuel prices to fall. At one point, oil futures for one-month delivery were trading at negative prices. Later in the year, a good monsoon meant a bumper harvest. Easing of the lockdown prevented increase in food prices. We are at the brink of seeing another episode of the scissor effect.

Seasonality of food prices and exogenous oil shocks usually correct over time. In that case, do policymakers need to worry about the divergence in core and non-core inflation? Even if this only a short-term effect, it exposes the structural issues that underlie India’s agricultural sector. Low incomes force farmers to borrow, even for consumption purposes. Agriculture requires upfront investment while returns are uncertain. It takes just one supply shock to send them into a vicious spiral of borrowings.


Buffer stock

The presence of a substantial excess buffer stock of grain with the FCI highlights the problem of plenty. In January 2021, it was expected that the buffer stock would be 2.7 times the requirement of the government’s welfare schemes. This is after the food distribution that was done during the nationwide lockdown. This points to the ineffective management of the food stock in the warehouses. It allows wholesalers to engage in practices like hoarding, leading to spikes in inflation. These supply shocks cause inflation to deviate from the trend and reduce the effectiveness of monetary policy.

In order to control inflation, there is a need to bring structural reforms in the agricultural sector and make the supply and distribution channels efficient. That was perhaps the goal in mind for the policymakers while drafting the recently enacted farm laws. It would allow farmers to sell outside the “mandis” under the APMCs, enter into forward contracts with agribusinesses and large retailers to sell their produce at pre-determined prices in the future, among other things.

While the intended benefits would help reduce the probability of supply shocks, the farmers would have to bear the brunt if there is a decrease in prices. Farmers fear that with this new system, the Minimum Support Price will be phased out, and they would be at the mercy of the large buyers for price determination. The problem would be worse for the small farmers with fragmented landholdings who would have little to no bargaining power. They would get reduced prices for their produce. Incomes would further fall unless the volume growth is good enough to offset the potential fall in prices.

Changing farm laws in isolation is not the solution to the structural issues in the agricultural sector. The benefits of an efficient supply chain need to be shared with the farmers. There should also be a system of checks on the large retailers who would purchase directly from the producers. Further, forward contracts are complicated financial products. Farmers must at least be made aware of the complications and risks associated with these contracts so that they are not exploited.

Even more important is to create opportunities for work in the non-farm sector to absorb the disguised unemployment in the agricultural sector. With reduced shocks, inflation expectations would be more accurate, increasing confidence of the market in the RBI’s monetary policy. Coordination between fiscal and monetary policy measures is vital when the economy is in a state of stagflation. Issues of the political economy need to be resolved first to get growth back on track.

Rohan is an MBA student and Das is Professor of Economics and Chairperson of Misra Centre for Financial Markets and Economy, IIMA.


Published on March 22, 2021

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