Are Food Prices Core To India's ‘True’ Inflation? A RBI Study Belies Transitory Food Price

Treating food price deviations as transitory in the setting of monetary policy is increasingly becoming untenable, according to a study by the Reserve Bank of India. If food price pressures persist and continue to spill over, a cautious monetary policy approach is warranted amid endemic food inflation and greater chances of spillover effects, the study showed.

Core inflation, which excludes volatile food and fuel, has been declining since 2022–23, even as food price shocks have been imposing upside pressures on core inflation. However, disinflationary monetary policy has counterbalanced this. Should this disinflationary force recede, upward pressures on core and headline inflation could get magnified and may run out of control, especially with aggregate demand picking up alongside cost-push risks amid geo-political tensions, according to a study by the RBI in its monthly bulletin for August 2024. Monetary policy is the only active disinflationary agent in the economy, the study said.

The study stated that the conventional treatment of food price perturbations as transitory in the context of monetary policy is increasingly unsustainable. The study added that the secular upward drift in food inflation expectations drives a large part of this increase in persistence. Past high food inflation episodes—intrinsic persistence—have a bearing on shaping these expectations, the study showed. The inelasticity of demand to price shocks makes food inflation persistence all the more worrying.

With spillovers to costs, service charges, and output prices, the danger of food inflation surfacing as a more generalised phenomenon has increased.

The study shows that food inflation has been rising since the second half of 2019, primarily driven by the secular upward drift in expectations. Intrinsic persistence is also found to contribute significantly to the food inflation process during this period; past food inflation developments, especially the high inflation episodes, have a bearing on shaping current food inflation movements. Extrinsic persistence or demand conditions contributed negatively to food inflation between 2020 and the first half of 2023. Most importantly, unfavourable supply shocks contributed significantly to elevated food inflation in 4 out of 5 years, that is, since 2019-20, invalidating the perception of these events being transitory in nature. In every year since 2019–20, with the exception of 2021–2026, the Indian economy has faced adverse supply disruptions in agricultural conditions, in contrast to the previous five years when mostly favourable conditions prevailed. During 2019–24, agriculture production and supply chains were affected by multiple heat waves due to strong El Nino conditions, crop production shortfalls due to uneven south-west monsoons, La Nina conditions impacting rainfall patterns in the post-monsoon season, unseasonal rainfall and hailstorms, and temporal monsoon variability. These repeated climate shocks also pushed food inflation up.

The impact of food inflation has been largely offset by the restrictive monetary policy stance and supporting rate actions, the study said. The impact of food inflation shocks on expectations outcomes would have been substantially higher in the absence of disinflationary monetary policy.

In the ensuing months, food price pressures have become unrelentingly persistent, even as core inflation, traditionally defined as the consumer price index excluding food and fuel, has fallen to historic lows, steered by disinflationary monetary policy.

Food inflation is impeding the alignment of headline inflation with its target in India and cannot be tolerated in setting monetary policy any longer, the paper states. High food inflation is seeping into households' inflation perceptions and expectations, with the potential for spillovers into non-food prices as demand for higher wages on cost of living considerations and rising input costs are eventually passed on as higher output prices, especially in a scenario of strengthening aggregate demand.

As a result, there is a danger that the beneficial effects of lowering core inflation can be frittered away, with adverse implications for the disinflation process underway and for policy credibility.

In fact, a deep dive into food inflation behaviour in the 2020s shows that high food inflation has become endemic.