Reserve Bank of India Governor D. Subbarao on Monday said it was unrealistic to expect the central bank to deliver on an inflation target in the short-term.

“In an emerging economy like ours it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. The RBI cannot escape from the difficult challenge of weighing the growth-inflation trade off in determining its monetary policy stance,” said Dr. Subbarao while addressing the meeting of Central bank governance group in Basel.

The drivers of inflation in India often emanate from the supply side, which are normally beyond the pale of monetary policy. In particular, given the low income levels, food items have a relatively larger weight in the consumption basket in India compared to advanced economies and even many emerging market economies.

India has three consumer price indices each covering different segments of the population with the weight for food ranging between 46 and 70 per cent. “Monetary policy, as is well known, is an ineffective instrument for reining in inflation emanating from supply pressures.”

“An alternative that is put forward is that we could target core inflation rather than headline inflation. That is not a feasible solution either.” An inflation index, with half the basket excluded from it, hardly reflects reality. Moreover, the exclusion of food from the core index can be justified if average food inflation is the same as the average non-food inflation. “If food inflation is higher, as is typically the case in many low income countries including India, then we would be underestimating inflationary pressures on a systemic basis. That would mislead policy prescriptions,” he added

Further Dr. Subbarao said India had a problem about which inflation index to target. The headline inflation index was the Wholesale Price Index (WPI), and that did not, by definition, reflect the consumer price situation. However, getting a single representative inflation rate for a large economy with 1.2 billion people, fragmented markets and diverse geography was a formidable challenge.

“The recent introduction of CPI-Urban and CPI-Rural is welcome, but it still does not solve the problem of heterogeneity.”

Transmission of monetary policy

“A necessary condition for inflation targeting to work is efficient monetary transmission. In India, monetary transmission has been improving but is still a fair bit away from best practice,” Dr. Subbarao pointed out.

There are several factors inhibiting the transmission process such as an asymmetric relationship between depositors and banks, administered interest rates on postal savings that are not adjusted in line with prevailing interest rate trends and rigidities in the financial markets. All these factors dampen the efficacy of monetary signals and complicate the adoption of an inflation targeting regime in India.

Given the compulsions of democracy and the large population of poor, any government in India had always to be, and indeed had been, sensitive to price stability even if it means sacrificing output in the short-term, said Dr. Subbarao, adding, both the government and the RBI had to factor in the short-term growth-inflation trade off in their policy calculations.

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