Impact of food inflation on headline inflation in India

Abstract

A commonly held belief in the 1970s was that price indices rise because of temporary noise, and then revert after a short interval (Cecchetti and Moessner, 2008). Accordingly, policy should not respond to the inflation because of these volatile components of the price indices. This led to the development of the concept of core inflation (Gordon, 1975), which is headline inflation excluding food and fuel inflation. It was strongly believed that in the long run, headline inflation converges to core inflation and that there are no second round effects (that is an absence of core inflation converging to headline inflation). In recent years, however, major fluctuations in food inflation have occurred. This has become a major problem in developing countries, such as India, where a large portion of the consumption basket of the people are food items. Against this backdrop, in the present paper, an attempt is made to measure the second round effects stemming from food inflation in India using the measure of Granger causality in the frequency domain of Lemmens, Croux and Dekimpe (2008). The results of empirical analysis show significant causality running from headline inflation to core inflation in India and as a result, the prevalence of the second round effects. They also show that food inflation in India is not volatile, and that it feeds into the expected inflation of the households, causing the second round effects. This calls for the Reserve Bank of India to put greater effort in anchoring inflation expectations through effective communication and greater credibility.