Food prices and inflation expectations: Should the RBI cut rates?

In contrast, core inflation-excluding volatile food and fuel prices-held steady at 3.7 percent. Simultaneously, worrying signs of an economic slowdown have emerged. GDP growth in the July-September quarter of FY2024-25 fell to 5.4 percent, the lowest in seven quarters. This marks a sharp decline from 8.1 percent in the same period last year.Food prices

Compounding concerns, the Reserve Bank of India’s (RBI) October State of the Economy report highlighted a loss of momentum in key high-frequency indicators.

With retail inflation breaching the RBI’s upper tolerance limit of 6 percent, all eyes are now on December’s Monetary Policy Committee (MPC) meeting, where a potential rate adjustment is on the table.

Where criticism of RBI is misplaced

Many critics of the RBI policy argue that food price inflation is primarily driven by supply- side factors-such as erratic monsoons and disrupted supply chains-that are beyond the RBI’s control. The response to high food price shocks should come from supply-side measures such as improving storage infrastructure, increasing cultivation, imports, etc. Keeping interest rates high is not going to bring down food prices in the short run. Thus, the suggestion is that the RBI should focus on non-food, non-fuel inflation- the so-called core inflation.Food prices

This criticism of the RBI policy is a bit naïve and misses the mark. The RBI is worried about the second-order impact of food inflation. They worry that persistent high food inflation will likely trigger higher inflation expectations, which will lead to higher wages and higher food prices.

The key issue that the RBI is concerned about is not the immediate wage demands in response to food inflation this year, which would likely only lead to temporary inflationary pressures. The real risk arises if such wage demands continue into the subsequent years, regardless of whether food inflation persists. This could unanchor inflation expectations, creating a dangerous feedback loop where businesses and households expect high inflation to continue indefinitely, regardless of the underlying factors driving it. In such a scenario, inflation does not fall even if the original supply shock that caused it dissipates.

How RBI links interest rates to inflation expectations

Accordingly, the RBI has consistently cautioned that prolonged high food inflation could heighten inflation expectations, potentially driving up wages and creating a feedback loop of rising prices. This concern was highlighted in the recent RBI study, “Are Food Prices Spilling Over?”. The study finds that food inflation is positively associated with inflation expectations

as measured by the RBI survey. This appears to be the basis of RBI’s stance of keeping rates high in response to high food inflation despite low core inflation. The logic is that high rates will prevent the spillover of food prices into expectations by keeping demand and consequently employment lower. When employment levels are low, workers are unlikely to demand higher wages despite increases in food prices. Similarly, firms are unlikely to increase product prices when the overall demand is low. Thus, the RBI intends to keep the economy below its potential so that food prices do not spiral into higher inflation expectations.Food prices

Weak assumptions undergird this model

However, the RBI’s policy response relies on two critical assumptions: that the RBI’s measure of inflation expectations accurately predicts actual inflation and that these expectations, as measured by RBI, influence wage adjustments. Our analysis finds that neither assumption holds true in the data.

First, we examine the association between the RBI-reported inflation expectations, which are based on surveys of over 5,000 urban households, and the actual future inflation in Figure 1. The orange line represents mean expectations based on the RBI survey, and the red line represents the actual inflation for the relevant period for which the expectations were measured. As it is clear from the figure, the two seem unrelated. In fact, inflation expectations, as measured by the Misra Centre at IIM Ahmedabad, which surveys business panellists (blue line), seem to track actual inflation much better than the RBI’s surveys.Food prices

Second, we also looked at the relationship between inflation expectations as measured by the RBI and the subsequent wage growth. We obtained data on wages from the annual survey of industries. We used regional variation in inflation expectations and wage growth for this test.We found no significant association between wage growth and inflation expectations reported by the RBI.

This disconnect raises important questions about the transmission mechanism underpinning the RBI’s policy stance. While the central bank’s concerns about unanchored inflation expectations are valid, its current methodology for measuring these expectations needs urgent refinement.

Expanding survey coverage beyond urban households, incorporating business perspectives, monitoring contracts with predetermined hikes such as rent, and expanding its surveys’ geographic and sectoral scope would provide a more accurate assessment of inflation dynamics. In fact, a reasonably correct inflation expectation measure should have been a precursor to the inflation expectation regime. Without a good measure of inflation expectations and evidence about its relationship with wage growth, we think a policy of keeping rates anticipating that expectations will rise seems too harsh on growth and employment.Food pricesHonda Cars India rolls out 3rd gen Amaze at Rs 7.99 lakh