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184 Economic Survey 2020-21 Volume 2

mainly supply driven and therefore not a monetary phenomenon. Theoretical work in
the area has used models with price and/or wage stickiness to show that targeting core
inflation maximizes welfare. When prices are sticky, mark-ups fluctuate and therefore
also distort relative prices. In these models, the flexible price equilibrium is restored
by central banks trying to minimize these fluctuations by targeting sticky prices.
Much of the literature assumes that markets are complete, allowing households to
fully insure against idiosyncratic risks. However, in the case of developing economies
there are two deviations from these assumptions: 1) inability of agents to smooth their
lifetime consumption, and 2) other structural differences such as a high share of food in
household consumption expenditure (Anand et al., 2015). Anand et al. (2015) contend
that while under complete markets, the choice of targeting strict core inflation is the
best policy, with incomplete markets, headline inflation targeting is welfare improving
relative to core inflation targeting. However, using a setup similar to Anand et al.
(2015), Portillo et al. (2016) find that core (non-food) inflation stabilisation is very
close to optimal even in the case of an economy with credit constrained consumers.
Portillo et al. (2016) find that an optimal measure of inflation targeting should provide
very low weight to food inflation. This weighting is much lower than the weightage
of food in Headline CPI. A recent RBI working paper (Nadhanael, 2020), analyses
weekly price data on 45 food items in India, for the period 2005-18, from the data
collected by the Directorate of Economics and Statistics, Ministry of Agriculture and
Farmers Welfare. The paper finds heterogeneity in the extent of price stickiness among
food products. The prices of food items change, on average, in 1.29 months. Vegetable
prices change at higher frequency than others (almost twice a month on average), price
of pulses changes thrice almost every 2 months, the price of milk changes once in five
months, and prices of eggs, meat and fish change on average once a month, prices of
cereals change once almost every three and a half months. Given this finding of wide
variations in the price stickiness of food items, the paper suggests that it is important
to pay attention to the sticky component of food inflation in addition to core inflation.

INFLATION EXPECTATIONS

5.29 The one year ahead inflation expectation for CPI-C inflation has risen during the current
year. As per the business inflation expectations survey of Indian Institute of Management (IIM)
Ahmedabad, one year ahead inflation expectations for CPI-C inflation slightly rose from 4.0
per cent in February 2020 to 4.4 per cent in October 2020. Inflation expectations survey of
households conducted by RBI also pointed to a slight rise in inflation expectations from 9.1
per cent in March 2020 to 9.7 per cent in November 2020, though it was lower compared to
September 2020. The movement in the inflation expectations have been roughly in the direction
of movement of the current inflation rate as measured by CPI-C (Figure 21). This has an important
implication with respect to the CPI-C being an important metric for monetary policy. Owing to
being a metric of price change that households can relate to it targeting headline inflation can
anchor inflation expectations.