Understanding the impact of volatility in food prices on CPI inflation and its consequence on inflation targeting in India

Abstract

The central banks of today have shifted to inflation targeting, wherein they set an inflation target/band for themselves and set a price index as a benchmark. The inflation targeting approach ensures accountability, transparency and better anchoring of inflation expectations, since the public is now aware of the goal of the Central Bank and knows that the policies so designed are meant to achieve that particular goal. However, the main impediment to an efficient inflation targeting seems to be the presence of volatile components, namely food and fuel, which hinder the ability of the central bank to effectively forecast and take monetary policy decisions.

Similar is the case with India, where in the weightage for food in the Consumer Price Index, the benchmark index used to measure and target inflation by the Reserve Bank of India (RBI), is 45.86%. Further, food happens to be one of the most volatile components of the price index. Our analysis shows the variation in food happens to be the greatest when compared to all the other components, and combined with its highest weightage, the coefficient of variation for food comes out to be the highest.

Therefore, the current high weightage for food presents problems for inflation forecasting and taking decisions.