Saturday, July 03, 2010

India's inflation problem

RBI raised rates, saying that they are concerned about inflation. What is the state of inflation in India? I find it useful to look at an approximate `core WPI' that is obtained by removing food and fuel from the overall WPI. This has to be done carefully because some food is present in WPI Manufacturing.

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:

MonthPoint-on-point change (annualised)
2009 Sep    1.61
2009 Oct    -0.11
2009 Nov    9.67
2009 Dec    5.12
2010 Jan    9.33
2010 Feb    2.93
2010 Mar    27.49
2010 Apr    -4.07
2010 May    34.86

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.

11 comments:

  1. I have a question sir. Why India calculates inflation on WPI rather than on CPI? Is it to fool the public or some factual reasons are behind it?

    One thing I found out is, why Indian Government and RBI keep on playing with Repo and reverse repo rates? Do they just want us to assume that they are working on broader manner? Because in previous year, when these key rates were pulled down, nothing much happened.

    Also, instead of increasing these key rates to contain food-inflation, why don't government of India contain people who are responsible for food price hike? There are some thousand tonnes of grains and vegetables rotting in open air or some godowns. Why not provide them into the system? Why contain supplies, then wait for demands to rise and then when there is nothing in hand, milk general public.

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  2. The Indian stock markets out-performance somewhat shows that India's high inflation seems like a God gift for bulls.
    Developed world is on the verge of deflation and are desperate for increase in aggregate demand. Nominal GDP seems to be falling.

    Globally commodities demand haven't increased but see the rise in value.

    It seems that stocks markets are disconnected from macroeconomics and aggregate demand. India is at Number One position and we should feel proud of that.

    Ironically, our corporates are also making a lot of money because of high inflation. Even wage increases across the various industries is not on higher side. Systematic looting of indian middle class is happening at brisk pace. Initially it was real-estate and now it spreads to even manufactured products too. India will remain high beta market and all this inflation will never upgrade it to alpha play.

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  3. India always ends up with the losing idealogy.

    It was one of the last colonies of the British empire. Partnership with Russia when communism is on the decline. Partner with US when it is in decline. Next aim is to be like China (especially in terms of anti-saving policies, asset bubble promoting policies) when it will be declining. We are well on the way with the last one. We have no scruples, no idealogy of our own, nothing.

    I am incapable of joining in with the celebrations of India having built a new state of the art terminal and a metro in Delhi. Its so late so as to lose its impact. The world has moved forward - the new issues of today are not how to build state of the art airports (airports themselves are not a state of the art thing, if you know what I mean) - that had to be done many decades ago. Today, it is merely an act of catching up.

    And, what do you expect the world to say - oh lovely, now your capital has a state of the art airport... atta boy. Or, should they instead go - what the hell took you so long? Now, would you please wake up and do something about the innumerable poor and illiterate people in your country? Would you do something about the fact that 60% of your people depend on agriculture, x% don't have clean water, etc, etc.

    Along the same lines, RBI has no meaning in India. It can whatever the hell it wants - it doesn't matter. Everything is broken, yet we will be the new superpower - just as long as the bankrupt OECD continues to buy widgets from us and the world continues its decline, it will surely catch up with India, by the looks of it - what a great business model - India, the last Asian tiger. Unfortunately, just like it happens to the last, weak animal in the herd, I doubt it will make it across the river.

    (This rambling is sponsored by ICICI Direct - superlative customer service that prompts our customers to get intolerably angry about everything in India).

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  4. Ajay,

    Do not exclude food and fuel from your analysis. Common man has to buy food and fuel every day.

    It is clear to me that crude oil is headed down, still they raised the fuel prices.

    The bleating in the papers of "oh, we provide a daily subsidy of 4000 crores" has gone away. Oil companies keep quiet when there is a daily profit of 4000+ crores. Breakeven price was $75 per barrel, now its gone to $65-70 after the recent price hike.

    Also, many banks should have refused the housing loans, which sow the seeds of future bankruptcy.

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  5. Ajay, a couple of follow up questions to the comments-

    1. I would think that with weak transmission mechanisms, conduct of monetary policy through rates would as you say be ineffectual. However, a coarser approach is tweaks to the reserve requirements itself, which the RBI has done from time to time. Would these not be more effective? If so, why is that not being done?

    2. The volatility of the month by month inflation is alarming. One of the outcomes of inflation targeting is that firms can plan the long term. But if its so volatile, it seems like we are going out on a limb by expecting that the long run inflation will be stable and predictable. Or is this how historically MoM inflation behaves in India (after seasonal adjustments)? If not, what's driving this volatility in core inflation?

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  6. HI Ajay,

    I think, this is the first time I have read some one criticizing RBI and its steps.

    I fail to understand why a central bank will pursue more than growth and inflation. Something is definately missing here.

    And there is no use of signaling, because RBI has little credibility in affecting rates through signalling. I wonder where RBI is on Phillips curve.

    I have a feeling that stock markets are not implying economic variables, rather economic variables are implying stock market valuations in India.

    If oil subsidy has been in place for god knows how many year, it could have been surely continued for few more months. If the whole of govt thinks inflation will come down by march 11, they could increase oil prices then or does it mean that govt is saying something while it is expecting something else. Only guys I know who have welcomed this are the ones who com on CNBC regularly.

    Somehow I think, while raising interest rate is delayed on account of growth, raising oil price is not delayed on account of inflation.

    I wonder if the whole of nation is lead by few capitalists to believe that India is flavor of the season and we must do whatever it takes to maintain our stock markets at higher levels.
    India may become an example where perceived capitalism leads to an oligopolistic economy instead of a competitive economy.

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  7. Amit Kulkarni - the reason economists look at core inflation (after removing food and energy) is to determine the trend of inflation. Food and energy prices are by their nature volatile and are rarely bounded by long term contracts. On the other hand for policy/planning purposes, long term trends are what matter - you don't change monetary policy on a day-day basis. Similarly, firms also use long term trends to price in inflation into their financial planning and thus cannot use volatile fluctuations to determine inflation. If policy makers want to figure out if firms are pricing in higher inflation, then again they have to look at core inflation.

    Neeraj - In the short run, there is a direct correlation between inflation and employment (you may want to look at the Phillips curve).

    That said, the more I think of it. is MoM really a good measure to look at if we care about long term trends for policy reasons. And if so, then I go back to my previous comment - it should not be as volatile, else its not useful as a trend predictor.

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  8. Is there an elephant in the room here that we all refuse to see? I mean, isn’t there a link between the high inflation that we are seeing now (particularly food inflation) and the recent vastly increased outlays on social “welfare” schemes?

    Take the example of all that money going down the NREGA drain. This has the immediate effect of injecting a lot of extra purchasing power into the economy without doing much on the output side (neither the short nor the long term). Naturally, inflation follows and this should be a no-brainer.

    A while back I read a news story purportedly about the “success” being achieved by the NREGA. It mentioned that farmers in Punjab were facing a shortage of labour to harvest their crops because of a slow-down in the hordes of seasonal migrants from U.P. and Bihar that earlier used to turn up for this kind of work. And this was because the NREGA, by providing them work near their villages, had made the trip to Punjab less worthwhile. Yes, this is heart-warming stuff.

    Unfortunately, economics has very little time for warm hearts. What is actually happening is this. Instead of doing economically productive work (harvesting crops), labour is being diverted into unproductive work (digging trenches), and getting paid in the bargain. It pushes up the costs for Punjab farmers, which invariably finds its way to the government in the form of higher minimum support prices, and it does nothing to increase output in the economy which might otherwise have absorbed the extra purchasing power created.

    And this is just so much about what has happened. What is in store for us is perhaps even worse. Wait till the Food Security Bill and its promise of food grains at Rs.2 (or Rs.3) a kilo becomes law. The government will then necessarily have to acquire a lot more rice and wheat from the market for supply to the “poor”. A lot of it will get pilfered or wasted in the logistics and in the hands of the end-user (knowing what happens to things given away for free), and importantly, it will also cut down on the supply available in the open market for purchase by our “aam aadmi”. At this point, it is simple demand and supply.

    Anyone who has a doubt about what I have just said should feel free to look up the inflation rate in Venezuela where our Comrade Chavez has lately been into a lot of social “welfare”.

    ReplyDelete
  9. Is there an elephant in the room here that we all refuse to see? I mean, isn’t there a link between the high inflation that we are seeing now (particularly food inflation) and the recent vastly increased outlays on social “welfare” schemes?

    Take the example of all that money going down the NREGA drain. This has the immediate effect of injecting a lot of extra purchasing power into the economy without doing much on the output side (neither the short nor the long term). Naturally, inflation follows and this should be a no-brainer.

    A while back I read a news story purportedly about the “success” being achieved by the NREGA. It mentioned that farmers in Punjab were facing a shortage of labour to harvest their crops because of a slow-down in the hordes of seasonal migrants from U.P. and Bihar that earlier used to turn up for this kind of work. And this was because the NREGA, by providing them work near their villages, had made the trip to Punjab less worthwhile. Yes, this is heart-warming stuff.

    Unfortunately, economics has very little time for warm hearts. What is actually happening is this. Instead of doing economically productive work (harvesting crops), labour is being diverted into unproductive work (digging trenches), and getting paid in the bargain. It pushes up the costs for Punjab farmers, which invariably finds its way to the government in the form of higher minimum support prices, and it does nothing to increase output in the economy which might otherwise have absorbed the extra purchasing power created.

    And this is just so much about what has happened. What is in store for us is perhaps even worse. Wait till the Food Security Bill and its promise of food grains at Rs.2 (or Rs.3) a kilo becomes law. The government will then necessarily have to acquire a lot more rice and wheat from the market for supply to the “poor”. A lot of it will get pilfered or wasted in the logistics and in the hands of the end-user (knowing what happens to things given away for free), and importantly, it will also cut down on the supply available in the open market for purchase by our “aam aadmi”. At this point, it is simple demand and supply.

    Anyone who has a doubt about what I have just said should feel free to look up the inflation rate in Venezuela where our Comrade Chavez has lately been into a lot of social “welfare”.

    ReplyDelete
  10. Is there an elephant in the room here that we all refuse to see? I mean, isn’t there a link between the high inflation that we are seeing now (particularly food inflation) and the recent vastly increased outlays on social “welfare” schemes?

    Take the example of all that money going down the NREGA drain. This has the immediate effect of injecting a lot of extra purchasing power into the economy without doing much on the output side (neither the short nor the long term). Naturally, inflation follows and this should be a no-brainer.

    A while back I read a news story purportedly about the “success” being achieved by the NREGA. It mentioned that farmers in Punjab were facing a shortage of labour to harvest their crops because of a slow-down in the hordes of seasonal migrants from U.P. and Bihar that earlier used to turn up for this kind of work. And this was because the NREGA, by providing them work near their villages, had made the trip to Punjab less worthwhile. Yes, this is heart-warming stuff.

    Unfortunately, economics has very little time for warm hearts. What is actually happening is this. Instead of doing economically productive work (harvesting crops), labour is being diverted into unproductive work (digging trenches), and getting paid in the bargain. It pushes up the costs for Punjab farmers, which invariably finds its way to the government in the form of higher minimum support prices, and it does nothing to increase output in the economy which might otherwise have absorbed the extra purchasing power created.

    And this is just so much about what has happened. What is in store for us is perhaps even worse. Wait till the Food Security Bill and its promise of food grains at Rs.2 (or Rs.3) a kilo becomes law. The government will then necessarily have to acquire a lot more rice and wheat from the market for supply to the “poor”. A lot of it will get pilfered or wasted in the logistics and in the hands of the end-user (knowing what happens to things given away for free), and importantly, it will also cut down on the supply available in the open market for purchase by our “aam aadmi”. At this point, it is simple demand and supply.

    Anyone who has a doubt about what I have just said should feel free to look up the inflation rate in Venezuela where our Comrade Chavez has lately been into a lot of social “welfare”.

    ReplyDelete
  11. I am an ordinary middle class Indian,working in a private firm. I wonder why government every year is increasing salary of government servants like this. (This year the pensioners get an additional 16% DA in Kerala) All this huge amount if given as subsidy, I believe price hike can be controlled to a great extent and can in turn help the aam admi.

    ReplyDelete

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