Expert take: A case for raising inflation target

By Anish Tawakley
Head of Research, ICICI Prudential AMC
March 01, 2017
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If the supply of food grows relatively slowly then food would become relatively more expensive than manufactured products

Given the continuing sluggishness in the economy, particularly the low capacity utilisation level in the industrial sector, it is worth asking whether the current inflation target is appropriate. In my view, current inflation target is too low to be consistent with optimal industrial capacity utilisation (i.e.full employment of industrial capacity).


There has been a lot of debate around whether the RBI should focus on the Wholesale Price Index (WPI) or the Consumer Price Index (CPI). There has, however, been relatively little discussion about the CPI target level itself -should it be the higher or lower than the original WPI target.

It will be worthwhile to note that the CPI and WPI are two different scales for measuring the state of the economy ­just as Centigrade and Fahrenheit are different scales for measuring temperature. Just as the value of “normal“ body temperature is different in the Centigrade scale (36.8) from the Fahrenheit scale (98.2), the CPI and WPI values that mark overheating of the economy can be different.

If we look at the long-term history , CPI inflation has on average, been approximately 2 percentage points per annum higher than WPI inflation. Specifically, if we look at the 22-year period starting 1995, CPI inflation has averaged 7.3% p.a. while WPI inflation has averaged 5.2% p.a

Historically, monetary policy was based on WPI and broadly worked with a WPI inflation range of 5-5.5%p.a. On an equivalent basis, therefore, the CPI norm would be over 7%. One could argue that we want the economy to operate at a lower inflation level than it has historically, but a shift to a 4% target appears a bit too severe.


It is important to note that the GDP deflator for the manufacturing sector was in negative territory (deflationary zone) during all of FY16 and has only moved up to 2.3% by Sep 2016 (data is available with a lag). With RBI policy rates at 6.25%, the manufacturing sector faces real interest rates of around 4%.

It clearly does not make sense to put further downward pricing pressure on the pricing environment in the manufacturing sector.

What is important to realise is that it is not possible to bring down overall inflation without putting further downward pressure on manufacturing sector prices. Let us see why this happens.

In any economy relative prices of various goods and services (the price of one good/service relative to another good/service) are a real variable (and not a monetary variable). For example, even if we had a barter economy with no money there would be a certain rate at which food would be exchanged for bicycles (a manufactured product). This exchange rate would depend on the physical demand and supply of food and bicycles respectively. This exchange rate or relative price would change depending on the change in demand and supply conditions.

If the supply of food grows relatively slowly then food would become relatively more expensive than manufactured products. Now if we introduce money in this economy, the gap between food price inflation and manufacturing price inflation is a real variable and, is not affected by the introduction of money (or by the monetary policy that determines how much money is introduced).

So to bring down average inflation, through monetary policy, you have to shift both food and manufactured products inflation downward. In effect you can't just shift food inflation down without affecting manufacturing inflation.


Let us look at the food stock situation and relate it to what has happened to food inflation.

Wheat stocks currently are at 5 years lows -stocks in December 2016 were 14 million tonnes down from a peak of 34 million tonnes in January 2013. Rice stocks had also declined but have recovered substantially over the last three months.

What this tells us is that the part of the reason that food inflation has moderated is that the government has supplied the market with stocks that had been built up historically. Stocks, of course, can't be depleted beyond a point.

While good harvests would help, one cannot rule out an uptick in food inflation as and when stock levels are stabilised or rebuilt.The fact that food subsidy sees a significant increase (7.5%) in the Budget this year also suggests that minimum support price increases may be higher this year. If monetary policy is tightened to restrain such an uptick then it could put further strain on the industrial sector.

This article was first published in Economic Times on March 01, 2017.