"No one can ignore Odisha's demand. It deserves special category status. It is a genuine right," said Odisha Chief Minister, Naveen Patnaik, earlier this month. The Odisha State assembly has passed a resolution requesting special category status and their demands follow Bihar's recent claim for special category status. The concept of a special category state was first introduced in 1969 when the 5th Finance Commission sought to provide certain disadvantaged states with preferential treatment in the form of central assistance and tax breaks. Initially three states Assam, Nagaland and Jammu & Kashmir were granted special status but since then eight more have been included (Arunachal Pradesh, Himachal Pradesh, Manipur, Meghalaya, Mizoram, Sikkim, Tripura and Uttarakhand). The rationale for special status is that certain states, because of inherent features, have a low resource base and cannot mobilize resources for development. Some of the features required for special status are: (i) hilly and difficult terrain; (ii) low population density or sizeable share of tribal population; (iii) strategic location along borders with neighbouring countries; (iv) economic and infrastructural backwardness; and (v) non-viable nature of state finances. [1. Lok Sabha unstarred question no. 667, 27 Feb, 2013, Ministry of Planning] The decision to grant special category status lies with the National Development Council, composed of the Prime Minster, Union Ministers, Chief Ministers and members of the Planning Commission, who guide and review the work of the Planning Commission. In India, resources can be transferred from the centre to states in many ways (see figure 1). The Finance Commission and the Planning Commission are the two institutions responsible for centre-state financial relations.
Planning Commission and Special Category The Planning Commission allocates funds to states through central assistance for state plans. Central assistance can be broadly split into three components: Normal Central Assistance (NCA), Additional Central Assistance (ACA) and Special Central Assistance. NCA, the main assistance for state plans, is split to favour special category states: the 11 states get 30% of the total assistance while the other states share the remaining 70%. The nature of the assistance also varies for special category states; NCA is split into 90% grants and 10% loans for special category states, while the ratio between grants and loans is 30:70 for other states. For allocation among special category states, there are no explicit criteria for distribution and funds are allocated on the basis of the state's plan size and previous plan expenditures. Allocation between non special category states is determined by the Gadgil Mukherjee formula which gives weight to population (60%), per capita income (25%), fiscal performance (7.5%) and special problems (7.5%). However, as a proportion of total centre-state transfers NCA typically accounts for a relatively small portion (around 5% of total transfers in 2011-12). Special category states also receive specific assistance addressing features like hill areas, tribal sub-plans and border areas. Beyond additional plan resources, special category states can enjoy concessions in excise and customs duties, income tax rates and corporate tax rates as determined by the government. The Planning Commission also allocates funds for ACA (assistance for externally aided projects and other specific project) and funds for Centrally Sponsored Schemes (CSS). State-wise allocation of both ACA and CSS funds are prescribed by the centre. The Finance Commission Planning Commission allocations can be important for states, especially for the functioning of certain schemes, but the most significant centre-state transfer is the distribution of central tax revenues among states. The Finance Commission decides the actual distribution and the current Finance Commission have set aside 32.5% of central tax revenue for states. In 2011-12, this amounted to Rs 2.5 lakh crore (57% of total transfers), making it the largest transfer from the centre to states. In addition, the Finance Commission recommends the principles governing non-plan grants and loans to states. Examples of grants would include funds for disaster relief, maintenance of roads and other state-specific requests. Among states, the distribution of tax revenue and grants is determined through a formula accounting for population (25%), area (10%), fiscal capacity (47.5%) and fiscal discipline (17.5%). Unlike the Planning Commission, the Finance Commission does not distinguish between special and non special category states in its allocation.
The Monetary Policy Committee (MPC) has decided to conduct an off-cycle meeting today to discuss the failure to meet the inflation target under Section 45ZN of the Reserve Bank of India Act, 1934. As per the Reserve Bank of India Act (RBI), 1934, MPC is required to meet at least four times each year, to discuss the macroeconomic issues in the country, and take policy decisions to address those. This is the second time MPC has conducted an off-cycle meeting in 2022-23. The meeting is scheduled in light of inflation being consistently high for nine consecutive months.
In this blog, we discuss what the inflation targeting framework is, examine retail and wholesale prices, and the divergence between them.
What is the inflation targeting framework, and what happens if inflation is persistently high?
In 2016, Parliament amended the RBI Act, 1934 to change the monetary policy, and introduce an inflation targeting framework. This framework prioritises price stability to achieve sustainable GDP growth. Price stability allows investors to confidently invest their money for productive activities, without worrying about it losing value. Price stability also maintains the purchasing power of consumers, i.e., the ability to purchase a good (or service) with a given amount of money.
As per the new framework, the central government, in consultation with RBI sets: (i) an inflation target, and (ii) an upper and lower tolerance level for retail inflation. The target has been set at 4%, with an upper tolerance limit of 6% and a lower tolerance limit of 2%. The upper and lower limits indicate that although it is desirable for inflation to be close to 4%, deviation between these limits is acceptable. The target and bands are revised every five years. In March 2021, the existing targets were carried forward.
Retail inflation has been above 6% for the past nine months, and it has been above 4% from October 2019 onwards (See Figure 1).
Figure 1: Consumer price index (year-on-year; in percentage)
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
If inflation is above or below the prescribed limits for three quarters, RBI must submit a report to the central government explaining why prices have been rising (or falling) persistently, what will be done to correct that, and an estimate as to when the target will be achieved.
The MPC uses tools such as interest rates to control the level of inflation in the economy. One such rate is the policy repo rate, which is the rate at which RBI lends money to banks. An increase in the policy repo rate makes borrowing money more costly, and hence is expected to control inflation by reducing the money supply. MPC increased this rate from 4% in April 2022 to 4.4% in May 2022, to 4.9% in June 2022, to 5.4% in August 2022, and to 5.9% in September 2022.
Breaking down the Consumer Price Index and the Wholesale Price Index
Consumer Price Index (CPI) measures the general prices of goods and services such as food, clothing, and fuel over time. Retail inflation is calculated as the change in the CPI over a period of time. Goods and services such as petrol, food products, health, and education are considered for its calculation, which are assigned different weights (See Table 1). Between February 2022 and August 2022, the average annual inflation was 6.9%. The rise in prices of subcomponents of the CPI during this period is indicated in Table 2.
Table 1: Assigned weights for the calculation of CPI
Sources: MOSPI; PRS.
Table 2: Average inflation of some CPI components
Sources: Database on Indian Economy, RBI; PRS.
CPI is not the only index that measures inflation in an economy. The Wholesale Price Index (WPI) measures the wholesale prices of goods. A change in wholesale prices reflects wholesale inflation. Table 3 indicates the weights assigned to goods for calculating the WPI. Manufactured goods include metals, chemicals, food products, and textiles.
Primary articles (23%) include food articles, and crude petroleum and natural gas. Fuel and power (12%) include mineral oils, electricity, and coal. WPI has remained above 10% from April 2021 onwards. It reached an all-time high of 17% in May 2022. This was driven by the inflation in metals, kerosene and petroleum coke, fruits and vegetables, and palm oil.
Table 3:Assigned weights for the
Sources: Ministry of Commerce and Industry; PRS.
Why has WPI inflation been consistently above CPI inflation?
Movements in the WPI have an impact on the CPI. For almost a year and half, CPI inflation has remained below WPI inflation. However, as per the design of the indices, it is expected that CPI would remain above WPI, and that any increase in WPI would reflect in the CPI after a time lag. This is because retail prices include taxes (as a percentage of price), while wholesale prices do not. Additionally, some of the goods in WPI act as inputs in the goods considered in CPI. An increase in input prices would lead to higher retail prices after a time lag.
We discuss possible reasons for why CPI has remained below WPI for a year and a half.
Figure 2: Consumer Price Index and Wholesale Price Index
Sources: Database on Indian Economy, Reserve Bank of India; PRS.
Composition of indices
As indicated in Table 2 and 3, the composition of the two indices varies. For instance, prices of manufacture of basic metals, chemicals, and machinery grew at an average rate of 13% between February 2021 and September 2022. They contribute 7% to the WPI. These are input goods for producing final goods and services such as automobiles, which are included in the CPI. The rise in prices of transport vehicles, communication devices, fuel for transport, and housing (CPI components) rose by 6% during this period.
The Ministry of Finance has observed that wholesale prices did not feed into retail prices (from March 2021 onwards) as wholesalers absorbed the rising input costs and did not pass them on to retailers. In August 2022, it noted that as retail prices are rising now, the pass-through may occur.