Understanding India’s inflation trends

The spike in retail inflation is due to food. RBI must not use it to increase policy rates

India’s inflation numbers are diverging once again. Retail inflation, as measured by the Consumer Price Index (CPI), grew at 4.6% in October on an annual basis. This is the highest in 16 months. The Wholesale Price Index (WPI) grew at just 0.2% in October though, the lowest in 40 months. These figures will be a key subject of discussion when the Monetary Policy Committee (MPC) of the Reserve Bank of India meets next month to decide on policy rates.

The short answer to why inflation numbers show a divergent trend is food. Food and beverages have a share of 46% in the CPI basket. This is only 24% for the WPI basket. The spike in retail inflation is mainly because of a seasonal shock to food prices, especially vegetables. In fact, non-food, non-fuel retail inflation is the lowest since January 2012. In terms of a trend, this is not very different from what the WPI numbers tell us. WPI for food group grew at 7.7% in October, the highest in 38 months.

There is very little monetary policy can do in terms of influencing onion prices when crops have been destroyed due to rains. However, the sharp fall in non-food inflation suggests that aggregate demand in the non-farm economy continues to be weak, despite RBI having cut policy rates in five consecutive MPCS. While it can be argued that rate cuts on their own are not enough to revive economic activity, there is good reason to believe that a reversal in the rate cut cycle can worsen matters even more. The central bank is mandated to keep headline inflation at 4%, within a range of 2 percentage points under the inflation targeting framework which guides India’s monetary policy. Even if the MPC expects food inflation to remain high in the near future, and this is a possibility, as unseasonal rains have destroyed crops in a lot of regions, it should be careful in unleashing rate hikes. The hallmark of good policy making lies in knowing when the tools at hand will work and when they won’t.