An employee weighs a container of chemicals on a scale at the Sheong Shi Tannery in Kolkata, West Bengal, India on Tuesday, Dec. 26, 2017. Photographer: Taylor Weidman/Bloomberg 

Monetary Policy Meet: Headline Inflation May Move Higher Towards Core Inflation, Shows JPMorgan Research

One of the key debates in the lead up to Thursday’s monetary policy committee decision is the divergence between headline retail inflation and core inflation. The latter is a component which strips out food and fuel inflation, hence giving a measure of inflation most impacted by demand conditions.

As per the latest available data, headline CPI inflation is running well below the mid-point of the MPC’s 4(+/-2) percent target due to low food prices. In December, it stood at 2.2 percent. But core inflation has remained high at between 5-6 percent.

Therein lies the dilemma for the MPC. Should the committee stick to its mandated headline inflation target and cut the repo rate? Or should it fear the high core inflation and retain a tight monetary policy stance.

The answer to that dilemma lies in answering this one question—will headline inflation converge towards core inflation? Or will core inflation converge towards headline inflation?

Also read: Monetary Policy Meet: Did India Pick The Right Inflation Target?

A Change In Inflation Dynamics

Against this backdrop, econometric research by JPMorgan economists Sajjid Chinoy and Toshi Jain, has found that until 2012, it was core inflation that used to converge towards headline inflation. However, from 2013 to 2018, it is headline inflation that has progressively converged towards core inflation.

For their analysis, JPMorgan has used a refined version of core inflation which further excludes elements that may be impacted by fuel prices. This measure is often termed as “core-core CPI”.

The JPMorgan study used monthly inflation data from 2002. It found that from 2002 to 2012, core inflation converged to headline inflation. But from 2013 to 2018, this dynamic changed and headline inflation has converged to core inflation, though not completely.
Monetary Policy Meet: Headline Inflation May Move Higher Towards Core Inflation, Shows JPMorgan Research

JPMorgan reasons that until 2012, shocks to food and fuel were either persistent or had second round effects, impacting core inflation. The transmission mechanism was likely through inflation expectations, which subsequently affected wage and price behaviour and eventually impacted core prices. Over time therefore, core inflation converged to headline inflation.

Urjit Patel Committee’s choice of headline inflation as the inflation target, was based on this rationale, added the note.

However, the recent bout of disinflation, has allowed inflation expectations to become more anchored. This, in turn, has led to more muted second round effects from shocks to food and fuel prices.

Against this backdrop, it is understandable why headline eventually converges to core inflation, ultimately reflecting underlying slack, explained the note.

What these results suggest is the headline inflation will eventually start converging, over a 12-month period, towards core inflation. If this happens, space for any monetary policy easing cycle—notwithstanding a one-off cut in February or April this year—would virtually evaporate.
Sajjid Z Chinoy, Chief India Economist, JPMorgan. 

Also read: Monetary Policy: If Not Cut Now, When?

Should We Target Core Inflation Instead?

One conclusion from the findings of JPMorgan’s research could be that the MPC should target core inflation instead of headline inflation. After much debate in 2013-2014 period, India had decided to target headline inflation.

Should this change? Chinoy and Jain argue that it should not. Reaching a conclusion to target core inflation is fraught with risk, they said.

The authors of the report argue that the inflation targeting has played a role in anchoring expectations. The change in inflation dynamics and a subdued second round impact of food and fuel price shocks is a testament to this.

Any backsliding from there runs the risk of causing expectations to get unhinged again, and for transitory shocks to get more generalized again.
Sajjid Z Chinoy, Chief India Economist, JPMorgan.