The rupee appreciation, of roughly 10% from 15 March to 6 April, has triggered a nice decline in WPI inflation. I have an article Combating inflation in Business Standard on understanding the inflation situation. Seldom in economics does reality throw up such an uncluttered demonstration of an idea.
The discussion on this blog entry offers many objections to my story:
- It was a `base effect'
- Prices did not go down - only rates of year on year growth of the WPI went down; therefore my explanation is wrong
- Maybe the supply side interventions of the government are getting through; maybe it is these which managed to bring inflation under control.
Let me start with the supply side interventions of the government - what I term `1970s economics' in the article. These have been going strong for a long time, before the rupee appreciation of 15 March. The documents released by the Ministry of Finance in February 2007 have a long catalog of things that were done in the previous year, in trying to attack one market after another: all these interventions were well in place before the INR appreciation. The graph in the BS article shows that none of this worked; it was the inappropriate use of policies that worked in an old India that are out of touch with an India which is a trillion dollar market economy.
As for the distinction between prices and yoy inflation, we know that in all countries, inflation has persistence. Once the inflationary fires are burning, they have a momentum of their own, since inflation creeps into the expectations of economic agents. So the default setting is that high yoy inflation is followed by high yoy inflation. The INR appreciation affected the prices of those goods which are priced by import parity pricing. For those goods, there has been an impact on prices, and I would imagine that for some of those goods there has even been a decline in prices in sympathy with a 10% change in the rupee. But these goods only account for a part of the WPI basket. Putting things together, we see continued inflation, though at a lower rate.
It's the only thing you could have expected. Nowhere in the world does inflation, which is rooted in the expectations of economic agents, stop suddenly and turn into deflation.
Finally, to `base effects', which seem to be popular amongst the folks in securities firms writing analyst reports about India. I'm a skeptic on ascribing an important role to `base effects'. They are a cop-out of economic analysis, for you say nothing when you say "there is a base effect". What is really interesting about the rupee appreciation is that it gave a turning point on the WPI series, exactly as predicted by the logic of import parity pricing. `Base effect' reasoning is devoid of such strength; it wouldn't give you an insight into turning points. The only situation where a base effect is important is where there is a big change in an administered price. That would kick up the WPI in a certain week in one year but might be relatively benign in the same week of the next year. There is no reason for expecting a base effect with WPI manufacturing. And, the effect I am describing in the BS article (that INR appreciation broke the inflation spiral) is stronger, not weaker, with WPI manufacturing.
Let's look at the evidence for WPI overall (my case is even stronger with WPI manufacturing).
The graph superposes the latest 52 points of yoy WPI inflation (overall) and the previous 52 points - i.e. the identical weeks of the previous year. The latest year happens to be the upper curve. Look at the features:
- Early in the previous year, there was a powerful and sudden rise of the WPI from week 15 to week 20 by 150 bps. There was no "base effect" in the next year - WPI just kept accelerating without regard for the previous year.
- Similarly, the drop in WPI from week 0 to week 15 in the previous year didn't generate a rise in this year.
- If the claim of the "base effects" people is that the fluctuations of one year are undone in the next, then the two curves should be mirror images. They are not.
- Then we move forward to the first vertical red line, which is 15 March, the date from which the INR appreciation began until the next vertical line where there was a sharp inflation acceleration in the previous year. In the period in between the two red lines, there was no base effect. Last year's inflation was flat at 4%, and in the current year, inflation dropped by 100 bps.
- That leaves the last 50 bps of the drop in inflation this year, where it's possible to say that there was an opposing (bigger) change last year. Say so if you like, but it still buys you no insight.