Which inflation should the RBI target?
The Reserve Bank of India (RBI) is entrusted with the responsibility of maintaining price and financial stability, and it has used interest rate and money supply to pursue this objective with unwavering determination. Yet, inflation has survived with matching persistence.
The index that the RBI uses to target inflation is the wholesale price index (WPI), which is the combined price of a commodity basket comprising 676 items. A few prices in this basket can be too volatile or outside the scope of the RBI’s monetary policy, leading to poor results.
Inflation is a measure of the rise in prices. Consumers are only interested in the prices of consumer goods, so central banks in many countries make consumer price index (CPI) their policy target.
Even among consumers, there are sub-groups who have more focused interest in specific baskets of goods. For instance, the CPI-IW (consumer price index for industrial workers) is relevant for the labour industry and is the basis for assessing dearness allowance, which is the price variant of wage component.
Similarly, the CPI-AW (consumer price index for agricultural and rural labourers) is of interest to agricultural workers.
All prices do not behave the same way and a few volatile ones disturb the underlying trend. Many countries therefore measure core inflation as a supplementary indicator while measuring headline inflation.
In the United States, the core inflation excludes food and oil from the basket because prices of these commodities do not respond to Federal Reserve policy. The excluded items differ from country to country depending on their volatility.
Since the scope of the inflation measured by the RBI is wide, inflation has not responded either to the increase in interest rate or control of money supply. The central bank policy must target the index of inflation on which it has sufficient ex ante control.
Core inflation reflects the broad underlying long-term trend of prices. If it is more than the target rate it would be because the economy is getting overheated and needs correction through monetary policy. At present, there is no assessment or use of core inflation, but it can certainly be measured from the available indices by eliminating volatile prices which exaggerate WPI. Excluding food and oil, for instance, would mean a core inflation of less than 2 percent.
Clearly, the RBI should not target inflation measured by WPI alone. A more relevant operative target for monetary policy – as it is for many central banks in countries such as Canada, Finland, Thailand or South Africa – is core inflation.
In India, core inflation – which can exclude fruits and vegetables, milk and edible oils – would measure the imbalance in the economy or the gap between ex ante savings and investment. Therefore, the RBI should at least use core inflation as a supplementary indicator while targeting WPI.