Scope of monetary policy in containing agflation

Abstract

Historically, food and oil prices have been omitted from the calculation of inflation indices. This is because it was believed that the volatility in both food and oil prices were very high and most of the times they were due to temporary supply side shocks. The volatility was not considered a part of the demand supply phenomenon that governs economic policy formulations. Since the last few years, the food prices, unlike a shock, have been on an upward climb. Agricultural produce is being used for a variety of other purposes today than just for consumption. Subsidies provided by developed nations to researchers/producers of renewable biofuels have been a source of huge profits for the latter. Hence more and more food produce is being purchased for the manufacture of fuels. The shortage of one food item leads to demand generation for its substitutes. Thus as wheat becomes scarce, the demand for rice will increase, thus pulling up rice prices. Products like cattle feed, that needs cereals as inputs during manufacture also gets costlier leading to increased prices of cattle, poultry etc. Thus there is a general increase in food price level due to a reduction on the supply side. It can be optimistically expected that the high prices offered for food produce will motivate farmers to produce more, thus eventually reducing the shortage and cooling the prices. But for this, the farmer should be able to invest and re invest into farming which will be possible only if this agflation does not lead a long inflationary period, cutting down the growth rate. Hence Central banks around the world and particularly the RBI in India should focus on containing this agflation. India works with the WPI when measuring inflation. But this index is dominated by the manufacturing sector. Hence agflation cannot be picked up early on by focusing on the WPI as it might be offset or cooled by the manufacturing sector s performance. Therefore, there needs to be a change in the index that RBI uses, so that Food prices are reflected fairly, as it is seen by the common man. The CPI measures prices as seen by the final buyer of the product and thus reflects reality more than the WPI. Ideally India should have a consolidated CPI developed for itself. Allowing for economic disparity India should at least consolidate its 4 CPIs into 2 one for rural and the other for urban. A 3 year moving averages of these values can be used as the index that RBI should concentrate on for formulating policies. Such an index would effectively track the trend, will be free of the base effect and the ability to project the trend will compensate for the current lag in data collection.