View: India be overestimating inflation and making skewed policy at the cost of higher growth


By Sachchidanand Shukla

Ambiguity in inflation assessment, because of deficiencies in data on prices, can pose significant challenges for monetary policymaking. However, there is also a ‘blind spot’ that enhances the possibility of misleading inferences due to data deficiency and could lead to policy errors.

GoI scrapped the results of the household Consumption Expenditure Survey (CES) for 2018-19. Reportedly, it is likely to conduct two fresh back-toback surveys in 2020-21 and 2021-22. A revised consumer price index (CPI) based on the new consumption basket (as per CES) is unlikely to be released before 2024. (The CPI series for base 2011-12 was released in January 2015.)


The key issue here is that the results of CES are used to rebase macroeconomic indicators. Thus, the construct of CPI, the nominal anchor for monetary policy, will remain unchanged (base 2011-12) over the next three years. Due to the delay in CES, there is realistic informational imperfection of inflation indices, which could induce policy errors and extract higher growth sacrifice.

Household (HH) consumption pattern has changed over the years. This is reflected in a sharp fall in the share of food items by about 10.8 and 9.6 percentile points (pp) to 48.6% and 38.5% in rural and urban India respectively over the last decade (as per 1999-2000 and 2011-12 CES). This trend is likely to have continued post-2011-12. Assuming similar annual changes, the share of food items is likely to have dropped by as much as 7 pp by FY2020.

Hence, any food-driven rise in inflation would end up overestimating the underlying inflation in the period ahead — as weight of food should be lower than what it was in 2011-12. Similarly, disinflation on account of food items would tend to underestimate the headline number. For instance, headline inflation surged to 5.5% in November 2019, and to 7.4% in December as food and beverage (F&B) inflation touched double-digits.

F&B accounts for 45.9% of the consumption basket (2011-12 base year) — if the weight of F&B was 7 pp lower, the headline inflation number would have been about 33 basis points (bp) and 41 bp lower in November and December, respectively. Likewise, the headline number would have been about 35 bp higher during October 2018-January 2019, when F&B items were in the deflationary zone.

Fruits of Higher Income

Besides, the internal composition of the sub-indices is also likely to have changed, with items such as cereals and products witnessing a decline in their weights, with fruit and prepared meals seeing a rise. Likewise, the share of expenditure on education, healthcare and recreation is likely to have risen on account of rising incomes. Per-capita incomes have doubled between FY2012 and FY2019.

Thus, basing monetary policy on a nominal anchor not revised in a decade may lead to costly policy mistakes and undermine the inflation targeting framework.

The monetary policy may be tighter or looser than warranted as the nominal anchor may not accurately reflect the underlying consumer price levels. Apoint-based targeting (the mid-point of 4% of the 2-6% range) would be suboptimal, even perverse in such a scenario.

RBI must use the ‘flexibility’ offered by flexible inflation targeting framework to overcome this problem. As per recommendations of the expert committee to revise and strengthen the Monetary Policy Framework (MPF), ‘the nominal anchor should be defined in terms of headline CPI inflation, which closely reflects the cost of living and influences inflation expectations relative to other available metrics’.

There is no doubt that CPI continues to be a superior indicator for the cost of living compared to other metrics. However, in its individual capacity, the accuracy in terms of reflecting the cost of living is likely to have declined, and will continue to do so, over the next few years.

The inflation targeting framework will be up for review in 2021. This issue must be acknowledged and solutions must be sought. In the absence of underlying data, one possible solution could be to construct an alternative CPI basket using extrapolated weights based on changes in consumption patterns over the last decade. Or it could continue to use the current CPI as the nominal anchor while setting higher or lower tolerance limits for rising or falling inflation on account of food and non-food prices. These solutions, however, are only second-best to targeting an updated CPI.

Having a rules-based framework, although necessary, is not sufficient to derive optimal policy responses. Rules are ultimately based on data, and it is important to strengthen the data collection and dissemination architecture in the economy to avoid policy mistakes.

The CPI basket must be reviewed more frequently so that it accurately reflects the cost of living. Britain, for instance, reviews its CPI basket every year, adding new items and removing irrelevant ones. Given that India is a fast-growing economy, consumption patterns are likely to change much more rapidly.

Kill the Old, Add the Mod

A cursory glance at India’s current CPI basket shows that it accounts for several outdated items such as VCR/VCD/DVD player, camera and photographic equipment, radio, tape recorder, audio/video cassettes, etc. Instead, new items (such as OTT, or over-thetop, platforms) need to be added. Besides, data collection could be expanded to cover ecommerce websites.

Accurate inflation measurement is fundamental to the conduct of monetary policy. Price indices serve as guides to monetary policy decision-making, as well as providing the primary mechanism for holding independent policymakers accountable. Blind spots may not be noticeable, but they are anything but small. As Carl Sagan said, ‘The absence of evidence is not evidence of absence.’

The writer is chief economist, Mahindra Group. With inputs from Rahul Agrawal

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