In today’s Finshots, we dive into some clever tricks the RBI and the government could use to bring down inflation.

But here’s a quick sidenote before we begin. We’re on the lookout for enthusiastic Insurance Advisors to join our team at Ditto Insurance! No finance or insurance background? No worries. We’ll train you from the ground up. Click here to apply.

With that out of the way, let’s get on to today’s story.

The Story

Price rises are just a part of life.

The other day, I went to the market to buy fish. And after buying a kilo, my wallet was practically empty. No money left for veggies. It’s a sting we all feel.

But it’s not just a problem for you and me. It’s a headache for the RBI and the government too. Economists call it inflation. And while they’ve been trying to make it more bearable for us, they’re kind of stuck. They just can’t seem to control it as well as they would like to.

So, what’s the solution, you ask?

Well, one idea floating around is to simply remove food from the inflation equation.

Wait… what? That might sound crazy, we know. But it’s not some wild theory. Serious analysts are considering the idea and even the latest Economic Survey makes a mention of this. And while it might seem nonsensical at first, hear us out.

Inflation has two main components.

First, there’s core inflation, which covers stuff like education, clothing, rent, healthcare, transportation and other household expenses. Notice anything missing?

Yup, food and fuel aren’t included here.

The second part is non-core inflation, which is where food and fuel come in.

Put these two together, and you get the headline inflation, also known as the Consumer Price Index (CPI).

For years, the RBI has been trying to get a grip on headline inflation. Back in 2016, the RBI and the government agreed to aim for a 4% inflation target. The idea was to have a roadmap to keep price rises under control, with a tolerance range of 2% above or below this target.

And to hit this target, the RBI has been raising interest rates, especially since the pandemic. Raising rates makes borrowing more expensive, so people and businesses spend less. In theory, this cools down prices. And it sort of worked. Inflation dropped from 6.2% in FY21 to 5.4% in FY24.

But here’s the catch. Despite the efforts, the RBI just can’t seem to hit that magical 4% target. The main culprit?

Food!

See, inflation can happen in two ways.

First, there’s demand-pull inflation. This is when there’s a lot of demand for something, so prices rise because people are willing to pay extra. Think of flight tickets. The more people want to fly, the more prices go up.

But then there’s cost-push inflation. This happens when prices rise due to external factors like increased costs of labour or transportation.

And this is exactly what’s happening with food prices. Even basic staples like onions, tomatoes and potatoes are getting more expensive, not because people are suddenly eating more of these foods, but because of things like erratic weather, heatwaves and supply chain disruptions. No matter how high the prices climb, people still need these essentials. It’s a supply problem, not a demand one.

Now, if you take food out of the inflation equation, the RBI has actually been doing pretty well. To put things into perspective, core inflation dropped to 4.3% in FY24, a four-year low. And that played a big role in bringing down overall headline inflation, which was the lowest among emerging market and developing economies (EMDEs).

But even though food prices have calmed down a bit, the RBI still can’t cut interest rates to boost the economy. Lowering rates would help businesses expand by giving them better access to capital. But the RBI has kept rates steady for nearly a year and a half now (since February 2023 to be precise).

That’s because it can’t just say, “Hey, core inflation is under control, let’s start cutting rates.” If it does that, people will have more money to spend, which could push up prices again, especially with food prices already high. And the RBI would be back to square one.

It doesn’t stop there. Rising food prices are also affecting other things. For instance, when food gets more expensive, households feel the squeeze, so they start asking for wage hikes. And when employers raise wages, they need to make more money to cover the cost, which pushes prices up again. It’s a vicious cycle.

That’s why some analysts suggest removing food from the inflation targeting framework altogether.

But hold on Finshots… Isn’t food a huge part of household spending? Haven’t you seen the latest Household Consumption Expenditure Survey? You better have, because it’s you who said that rural households now spend about 46% of their money on food, and urban households spend close to 40%. So how can anyone seriously suggest kicking food out of the inflation targeting framework, when it’s such a big chunk of our expenses?

Actually, you’re right. And we had the same thought too.

But here’s the thing. The CPI is calculated by looking at how much households spend on close to 300 different items and services, each with its own weight depending on how important it is in the average household’s budget. And here’s the kicker. The CPI basket includes outdated stuff like horse cart fares, prices of video cassette recorders and costs of audio and video cassettes. I mean, who uses that anymore? So, yeah, the CPI basket is a bit outdated.

The same goes for food. The weight assigned to food in the CPI has been stuck for over a decade, all thanks to the previous Household Consumption Expenditure Survey which was conducted over a decade ago. Back then, rural households allocated nearly 53% of their expenses on food, and urban households spent 43%. But those numbers have dropped since. So based on that, the CPI’s current 46% weight for food is a bit exaggerated.

That’s why, instead of removing food entirely, maybe it makes more sense to just update the weight assigned to it in the CPI calculation. And guess what? The government is already considering this.

Will tweaking the food weight in the CPI really help the RBI control inflation better? Or is removing food from the headline inflation framework the smarter move?

We’re not economists, but here’s one thing we know. Whatever they do won’t magically make our groceries cheaper. Even the RBI governor himself isn’t convinced that it’s wise to take food out of the equation entirely.

But at least fixing the weights and the basket could give us a more realistic picture about inflation.

Until then…

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