The results from India's state level elections confirm what many hold as one of the self-evident truths of Indian political life: when the price of onions rises, governments unravel. Anti-incumbency is just another name for this profound relationship.
But just as onions are a staple of the Indian diet, inflation volatility seems to be a staple of the Indian political economy.
Over the past decade, the Reserve Bank of India (RBI) has claimed a victory of sorts by refusing to allow inflation to plunge too low or soar too high. But this is little consolation to most households. From 2002 to 2006-07, inflation levels in India hovered around 4 per cent to 6 per cent and then exploded to highs of 16-17 per cent in early 2010.
The RBI has held various forces responsible for its inability to battle inflation effectively. These factors seem viable but the question that few bother to ask is whether the RBI sees inflation correctly.
The RBI measures two kinds of inflation: ‘headline' and ‘non-food manufacturing products' inflation. The headline index is derived from the wholesale price index (WPI) and calculated using three categories: primary articles, fuel products and manufacturing items.
The non-food manufacturing sector (NFMS) inflation, meanwhile, is that which is observed after stripping out food products from the manufacturing sector and clocks in at around 52 per cent of the headline inflation.
This sector (NFMS) inflation is a rough, but good, proxy for what the Federal Reserve in the United States calls core inflation.
Headline and core inflation
Monetary policy in India, in theory, targets headline inflation by tackling core inflation with interest rate hikes or declines. There are three major arguments made to justify this core-to-headline targeting strategy that US Federal Reserve President James Bullard among others has begun to question.
The first is the volatility argument. This claims that headline prices are volatile and any credit policy that reacts to this volatility will therefore be volatile. So, the argument goes that the monetary authorities must focus on relatively stable measures that they can oversee. The flip side is that then small movements in core-inflation might just be statistical noise. The system may be overwhelmed by large headline volatility and the policy reactions might be muted.
The second argument made to justify the targeting core policy is the claim that core predicts headline inflation. So far, I have rarely seen any evidence that conclusively proves that core inflation is any predictor of the headline inflation.
Finally, households and societies have budgetary constraints, so when price levels for one set of commodities rise, households react by consuming fewer goods that didn't get more expensive. Clearly, tracking core inflation poses more issues than perhaps it purports to address. It is manifestly true that the strategy of targeting core inflation is increasingly coming undone.
The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.
