Inflation Shouldn’t Seem Out of Touch with Reality

Newsreel Asia Insight #326
October 3, 2024

Raghuram Rajan, a former Governor of the Reserve Bank of India (RBI), says in a media interview that he is opposed to the idea of excluding food prices from the calculation of headline inflation—essentially the overall change in prices. His concern stems from the importance of maintaining the trust and credibility of the central bank in the eyes of the public, as well as its effects on the economy and society.

In an interview, PTI asked Rajan, a professor of finance at the U.S.-based Chicago Booth, about a proposal by V. Anantha Nageswaran, Chief Economic Advisor to the Government of India, to not include food prices from inflation calculations.

Rajan said it is optimal for inflation targeting to focus on a “basket” of goods and services that consumers actually purchase, as this directly influences their perception of inflation and ultimately shapes their expectations regarding future inflation.

Let’s break it down using a simple analogy.

Imagine you’re in a small boat, trying to keep it balanced so it doesn’t tip over. Now, think of the boat as the country’s economy, and you, along with the central bank, are in charge of keeping this boat stable. You’ve got tools to help you balance, like adjusting weights (in this case, interest rates) based on how the boat is tilting.

Now, suppose someone suggests not to consider the weight of the food supplies on board when balancing the boat. It might sound okay initially because food weights can fluctuate a lot and might seem unpredictable. However, if you start ignoring the food, even though it’s causing the boat to tilt, you’re not really helping anyone. People can clearly see and feel the boat tilting because of the food’s weight. They won’t trust your ability to keep the boat stable if you ignore one of the most noticeable weights.

In economic terms, Rajan believes that if the RBI doesn’t account for food prices when setting interest rates, it would be like ignoring a major factor that affects the cost of living for everyone. Since food is a significant part of everyday expenses for most people, excluding it from inflation measurement would make the central bank’s statements about inflation seem out of touch with reality. If people keep seeing high food prices but are told inflation is low, they might start losing trust in the central bank’s ability to manage the economy effectively.

The RBI adjusts interest rates to either curb inflation when it’s too high by making borrowing more expensive, or stimulate spending and investment by lowering rates when inflation is low and economic growth needs a boost.

Nageswaran is for exclusion of food inflation from interest rate decisions because food prices are influenced by supply-side issues (like crops failing due to weather), which the central bank’s policies (like changing interest rates) can’t directly control in the short term.

However, Rajan counters this by pointing out that even if food prices are initially beyond the central bank’s control, persistent high food prices indicate deeper economic issues that need broader adjustments, possibly by making changes in other areas that the central bank can influence.

For example, if food prices, which are a substantial part of most households’ expenses, are excluded, the central bank may underestimate the actual inflation experienced by consumers. This could lead to less stringent monetary policies – like lower interest rates – than are needed, potentially causing the economy to overheat and create more inflation in other sectors.

Further, inflation figures are often used to adjust wages, social security benefits and pensions. If these figures don’t include food prices, wages and benefits might not keep up with the actual cost of living increases faced by individuals, particularly affecting lower-income families who spend a larger portion of their income on food.

Furthermore, by not accurately addressing inflation in food prices, the gap between different income groups might widen. Lower-income households, who are more sensitive to changes in food prices, would suffer more from their effects, while higher-income households might not feel the pinch as severely.

Therefore, while excluding food prices from inflation calculations might simplify some aspects of economic management, the larger implications could undermine monetary policy effectiveness and distort public perceptions of economic stability. In other words, the simplicity of calculations should not take precedence over maintaining the central bank’s credibility and the financial well-being of citizens.