The right way to think about inflation is to not compute the year-on-year change in prices -- this shows the average inflation over the last 12 months. The right path is to compute month-on-month changes. This requires care about seasonality. These results are taken from the http://www.mayin.org/cycle.in website:
|Month||Point-on-point change (annualised)|
In September and October 2009, inflation was at sub-target levels: this was a time to cut rates. After that, inflation has reared up again. In particular, the rise in prices in March when compared with February was 27.49% (annualised). And in the most recent data, the rise in prices in May when compared with April was 34.86% (annualised). In other words, if prices rose for a year the way they rose from April to May, this would yield 34.86% YOY inflation within 11 months.
We find it useful to smooth this using the three-month moving average:
It makes sense for RBI to raise rates under these conditions.
Will it help matters?
Only a little.
In a well functioning market economy, small changes in the short rate by the central bank propagate all across the economy, into myriad asset prices, through the `monetary policy transmission'. In India, given the malfunctioning Bond-Currency-Derivatives Nexus and the lack of competition in banking, very little happens in the economy by way of reduced aggregate demand when RBI raises rates.
One feeble channel which works is : when local interest rates are higher, more money comes into India, which gives a stronger rupee, which helps control inflation. This effect is also weakened owing to capital controls which interfere with such adjustments.
In short, RBI was right to raise rates; inflation is a serious problem; but RBI is mostly ineffectual in fighting inflation given the weakness of the financial system and thus the monetary policy transmission.
What about the impending impact of the fuel price hike?
What about the impending impact of the fuel price hike? I have mixed feelings on this. If monetary policy was well structured in India, economic agents would have firmly grounded inflationary expectations. In that hypothetical world, economic agents would know that the central bank surely pursues an inflation target. The central bank would say what it would do, and it would do as it said. Under these conditions, the central bank governor would merely point out to agents that the oil price shock was but transient, and that the central bank will ensure that the inflation target will hold in the medium term. As a consequence, economic agents would shrug off the oil price shock, and it would not feed into broad-based inflation.
This is not the world that we live in. Inflationary expectations in India are not grounded. We do not know what RBI will do. Worse, RBI staff repeatedly gives out speeches promising us that they have multiple objectives, that the specific mix of objectives will change from time to time without transparency. So we are repeatedly reminded that RBI is not focused on inflation. In addition, the financial system is weak owing to a lack of financial sector reforms, so even when RBI moves against inflation, they are mostly ineffectual. Hence, monetary policy in India has little credibility in fighting inflation.
Hence, the shock from the fuel price hike will feed into broad-based inflation to a greater extent. Hence, it should matter to RBI's thinking about the outlook for inflation. You reap as ye sow.