A man holds out Indian rupee banknotes in an arranged photograph at a market in Ahmedabad, Gujarat, India (Photographer: Dhiraj Singh/Bloomberg)

BQExplains: Understanding India’s Inflation Landscape

India has frequently faced an inflation problem. At most times in the past, the problem has been high inflation. Now some experts fear that inflation in India is too low. But not everyone agrees. Inflation, by some measures, is low. But by others, it remains high.

By definition, inflation is the average rate of increase in the price of a basket of goods. The basket is selected in a manner that is representative of a typical consumption basket across various cross-sections of the economy. The rate at which prices are increasing is impacted by a host of factors such as supply, demand and the cost of raw materials.

High inflation is bad for consumers but very low inflation can be bad for producers.

A central bank decides (either formally and informally) on an appropriate level of inflation for the economy and sets interest rates to influence demand in the economy and, eventually, the inflation rate.

But there are many ways to measure inflation.

Consumer Price Inflation

The Indian central bank, the Reserve Bank of India, moved formally to an inflation-targeting regime in 2016. Under the new regime, a flexible inflation target of 4 (+/-2) percent has been set for the next five years. The six-member Monetary Policy Committee is mandated to meet that target.

The inflation metric that the MPC targets is consumer price inflation or retail inflation. Forty percent of this index is made up of food items. Fuel and power accounts for 6.8 percent of the index. Housing constitutes 10 percent, while clothing and footwear accounts for 6.5 percent of the overall index.

CPI inflation was at a seventeen-month low of 2.33 percent in November largely driven by fall in crude oil price and food disinflation or a contraction in food prices. Also, a break-up of inflation in urban and rural areas shows that rural inflation is running low at 1.7 percent in November, while urban inflation is higher at 3.12 percent.

BQExplains: Understanding India’s Inflation Landscape

Core Inflation

Not everyone is convinced that inflation in the economy is low. Many economists, including some at the central bank, prefer to look at a refined measure called core inflation.

Core inflation strips out volatile food and energy prices because they cannot be influenced by monetary policy. Some economists also measure ‘core core inflation’ by further excluding items like transportation and, in some cases, gold and jewelry. Once those items are excluded, economists get a better sense of whether there is a demand-supply imbalance in the economy.

If aggregate demand in the economy is rising at a pace much stronger than the increase in supply, core inflation will be high. This could justify an increase in rates even if headline inflation is low.

That is exactly what is happening in India right now. While headline inflation is at a low 2.33 percent, core inflation has remained between 5.5-6 percent. This has led to a debate on whether the MPC should maintain a tight monetary stance or move towards easier monetary policy and rate cuts.

BQExplains: Understanding India’s Inflation Landscape

Inflation Expectations

When analysing inflation, economists and central bankers also take ‘inflation expectations’ of households into consideration. Households react and make decisions according to their perception of the expected price changes in their consumption basket. As such, inflation expectations are often self-fulfilling.

The RBI conducts a survey of household inflation expectations. Recent results from this survey suggest that inflation expectations of households have moderated over a short-term horizon but remain elevated over a longer time-period.

Some members of India’s monetary policy committee see this as a red flag. But even here there is debate.

Ravindra Dholakia, one of the six members of the MPC, argues that inflation expectations of businesses and rural consumers should also be measured separately to get a broader sense of inflation expectations. Based on an IIM-Ahmedabad compiled business inflation expectations survey, expectations of price rise are moderating.

BQExplains: Understanding India’s Inflation Landscape

Nominal Rates And Real Rates

Getting the forecast of inflation right is important in setting interest rates in the economy. This is especially true in an inflation targeting framework, where the inflation forecast is used as the intermediate target. In other words, the forecast is used to determine the appropriate monetary policy response.

Once the MPC sets a policy rates, interest rates on all kinds of loans and securities are benchmarked to the policy rate.

Each of these rates is expressed in nominal, or current price terms. What matters more to lenders and borrowers is the ‘real rate’. The real rate is broadly the nominal rate adjusted for inflation. What it represents is the amount a borrower pays (or the amount a lender earns) over and above the rate of inflation. As such, it is often considered a better benchmark for borrowing and lending decisions.

In the prevailing environment in India today, real rates are considered to be too high. This is because policy rates were set based on the RBI’s inflation forecasts. However, actual inflation has fallen below the levels projected by the central bank. The result is that real interest rates are considered to be too high.

Some fear this could hurt economic growth in the coming quarters.

BQExplains: Understanding India’s Inflation Landscape