Interest Rate Cuts Are Not The Reason For Spike In CPI, Blame Food Inflation

On 13 January, National Statistical Office (NSO) released inflation figures for December 2019 with consumer price index (CPI) up at 7.35 per cent, which is a five-and-a-half-year high. This is well beyond the 6 per cent mark, which is the upper tolerance level.

The fact that CPI figure is at 7.35 per cent hints at a pause to the rate cut cycle in February’s Monetary Policy Committee (MPC) meeting.

However, these figures ask a more emphatic question regarding the monetary policy framework and our choice of an indicator. But more importantly, it gives a nice opportunity to some in order to draw erroneous conclusions regarding a link between CPI inflation and rate cuts that were experienced throughout 2019.

No, those rate cuts are not responsible for the current hike in CPI as this increase is primarily driven by food inflation. With vegetable segment witnessing an inflation rate of 60.5 per cent compared to previous year illustrates this point.

Consequently, food inflation was close to 14.12 per cent as against negative 2.26 per cent in 2018. For pulses and products, it was at around 15 per cent and for fish it was at 10 per cent. Therefore, clearly our CPI numbers are higher thanks to food items exerting an inflationary pressure.

This also implies that our non-food inflation continues to be muted, a fact that is also represented by our wholesale price index (WPI). It is intuitive and obvious that monetary policy or rather interest rates cannot impact the demand for food articles and therefore, to combat food price inflation with monetary policy would be absurd.

Sure, one could reduce inflation expectations through an extremely hawkish stance but that is only going to impose a substantial cost on the economy due to growth being forgone. Paul Volcker’s tenure at the US Federal Reserve is an excellent example of the cost of combating inflation that was driven by non-monetary factors.

This brings us back to an old debate between Dr Arvind Subramanian and Dr Raghuram Rajan during the early days of Narendra Modi government when we were discussing the possibility of an inflation targeting framework.

Dr Subramanian stated how WPI may be a better indicator as monetary policy does have an impact on it in contrast with the CPI. Dr Rajan’s argument was driven by the fact that consumers end up observing and paying CPI and therefore, their expectations on future inflation depends on CPI.

Therefore, one should try to moderate inflation expectations by targeting the CPI and keeping it below a threshold.

However, the problem with the view presented by Dr Rajan is that inflation expectations are not just dependent on CPI or past experience with inflation. There can be a positive inflation bias that creeps in due to historically high inflation rates.

In such a situation, any inflation expectation survey is likely to lead to problematic situation. Case in point; if you ask anyone if prices will increase of a particular commodity in future, they are more likely to say yes and give a random number, say by 5 per cent than they are going to say a no. People expect prices to go up in India, that is how we have grown up and that is how we are wired.

Another point is that any attempt at anchoring inflation expectations must be weighed with the cost associated with the same. At the moment we do have a substantial negative output gap and monetary policy transmission continues to remain a major problem despite a series of rate cuts.

This means that our real rates if defined using WPI may have only gone up rather than coming down as WPI has been more or less under 1 per cent.

The fact is that both these indicators of inflation diverge because of different weights and baskets of goods and services. Therefore, it is possible for CPI to be high while WPI remains subdued.

The question is what must be done in such a scenario and the answer is fairly straight forward — if the CPI is being driven by food inflation, then one must accept that monetary policy won’t have much impact on the same.

This acceptance is important as we must resist the temptation to act without recognising the costs associated with any improper action. Any hike in rate may further worsen the real cost of capital for our companies.

Now comes the question regarding rate cuts — should there be any? Perhaps, but only for the real lending rates. The focus now should be to drive down the prime lending rates and government security (G-Sec) yields in order to ensure transmission.

While there may be high CPI for now, do remember that it is driven by food inflation and therefore, we need to be careful with how we react to the same on the monetary front.

But does this mean that food inflation is back? Not really. One seasonal and other natural factors that caused a spike in food inflation due to supply disruptions get resolved we can anticipate substantial moderation in inflation rates.

This is precisely why we must revisit the possibility of a front-loaded rate cut in the month of April.