Noise and signal

Retail inflation has pierced past the upper bound of the Reserve Bank of India (RBI)’s 2-6% target.

Exactly a year ago, it was dormant around 2% and until August 2019, humming along 3%.

Along with slowing growth, more-than-desirable inflation raises the sceptre of stagflation (where inflation rises even as output and employment fall)

An unwanted complication in an already slowing economy that central banks dislike.

That’s also a big reason why an inflation-targeting Monetary Policy Committee (MPC) stood pat during its December review, going against the street consensus.

But just how valid is this concern?

A closer look shows the current spike in inflation comes from transitory or idiosyncratic factors.

Let’s call them ‘noise.’

Theoretically, the noise in consumer price index (CPI)-based inflation reflects sharp price movements in certain volatile categories. These happen because of commodity price fluctuations, and weather and supply shocks.

Typically, they don’t last long, so are unlikely to become a cause of sustained increase or decrease in inflation.

In India, and generally, too, fuel and food are way more volatile¹ than core inflation². Put another way, they’re more prone to making noise.

Remove noise, get the signal

Now, core is what’s left if you remove noise.

That, then, is the ‘signal’, which indicates the underlying inflation in an economy.

Core has a greater weight (51.8%) in the CPI series, than food and fuel (48.2%).

The share of noise in headline inflation has gotten louder, from a miniscule 18.5% in April 2019 to 74.9% in December.

Also, pay attention: Much of this rise is on account of food inflation. The fuel category was witnessing deflation till November and turned marginally positive in December.

In short, food is the current noisemaker.

¹Measured by standard deviation (Jan 2015-Dec 2019)
²Core measures inflation sans food and fuel