## Wednesday, April 02, 2008

### How to control inflation

WPI inflation is up to 6.68% and the government is ready to do battle.

I wrote an article in Business Standard titled How to combat inflation where I suggest that the way to bring monetary policy back to balance is a 10% rupee appreciation coupled with a 300 bps drop in the short-term interest rate.

In this reasoming, I think the drop in the US dollar is important in understanding the global rise in commodity prices. As Ashok Gulati and Kanupriya Gupta say in Hindu Business line:

Our humble submission is that before any policy prescription is offered; let us get the diagnosis right. While most of the factors that these studies talk about are right and appropriate, many of them compare 2007 prices with those in 2000, and that too in current dollars, to arrive at their conclusion of gloom.

This, we opine, is not appropriate, if not misleading. The reason is simple: anyone dealing with agricultural prices knows that agricultural prices in 2000 were at their rock bottom resulting primarily from the East Asian crisis. No one expected those prices to stay at those levels, as East Asian economies started to recover. Maybe the pendulum has now swung a little on the other side.

Another reason is that 2007-08 prices need to be put in a long-term perspective, say at least from 1990 to 2007. And when one does that, the minimum one needs to do is to take the prices in constant US dollars. One can take the base year as 1990, or 1995, or even 2005, for converting the price series into constant US dollars, but not the year 2000, for the reasons explained above.

However, in a situation when US dollar is fast losing its strength in the international exchange market, it may be more appropriate to look at prices in constant euros (with base year of 1990, or 1995 or 2005).

We have done this exercise for the major agricultural commodities such as wheat, rice, palm oil, and sugar, at constant 1995 US dollars as well as at constant 1995 euros. And the results are revealing (see Graphs).

The upshot of these results is: the 2007 global prices of agricultural products are not very much out of line with what they were in say 1996, just before the East Asian crisis. These prices started rolling down in 1997 due to East Asian crisis, touched a rock bottom in 1999-2000, and then recovered over time. Today, they are a little on the other side of the swing.

1. There are many things about your article that I wish to comment upon. But I lack time and also to keep matters simple I will comment in small bites.

"When inflation spikes, the single focus of the government becomes controlling inflation. This is not how mature market economies work. In all mature market economies, the task of controlling inflation - and only the task of controlling inflation - is placed with the central bank. In mature market economies, inflation crises do not arise, because the full power of monetary policy is devoted to this one task."

Let me quote the Fed

"What are the Federal Reserve's responsibilities?

Today, the Federal Reserve's responsibilities fall into four general areas:
*conducting the nation's monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices....................."

From: http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm#3

Note that the above is responsibility no. 1 and full employment comes prior to stable prices.

This is the theory. Is the practice any different? Not if you consider this decade itself when the Fed has repeatedly lowered interest rates and did so earlier in the 1980s and 1990s as well .

Of course, you have not defined mature market economies - maybe the US doesn't qualify.

What about Japan? Its central bank has been trying to reflate/inflate the economy for a long time now and so have the authorities in the UK and Euro-region at different times and in different circumstances.

Not that they restrict themselves to interest rates. Two famous examples - Plaza and Louvre Accords which involved forex markets interventions (both governments and central banks of several coutries co-ordinated efforts).

Not you may not approve of such interventions - but I am making a limited point. "Mature market economies" follow varying objectives at various points of time. Your contention that "In all mature market economies, the task of controlling inflation - and only the task of controlling inflation - is placed with the central bank." is put it very, very mildly, completly wrong.

2. The legislation underlying the US Fed is ancient and out of date when compared with modern economics.

From Paul Volcker's time onwards, the US Fed has been a de facto inflation targeting central bank - even if their mandate says something different. Note that inflation targeting does not mean the weight of the output gap in your Taylor rule is 0.

The Plaza Accord etc. are an aeon ago. Today, central banks in well run countries do not trade the currency market except for once-in-a-blue-moon events (e.g. NZ last year). Yes, Japanese monetary economics is not too mature.

3. I mentioned Plaza (1985) and Louvre (1987) precisely because they post-date taming of inflation in the early 1980s and the inauguration (??) of the modern monetary economics policy making. But let's not forget that Britain was defending the pound as late as 1992. (15-20 years is hardly aeons ago).

The major point, however, was not about interventions in the forex markets (the point being that they even did that) but about massive interest rate reductions to meet employment/output objectives and not being restricted to mere inflation busting. You didn't respond to that.

CBs have intervened frequently (in the US it seems twice a decade, since the 1980s) in the past 25 years or so, primarily reducing interest rates, to boost the economy. This is true of all "mature market economies". Hence your contention about CBs being concerned only about controlling inflation is off the mark.

In fact during the last six months the Fed has gone to extraordinary lengths (starting with reducing rates but then increasing the period of accommodation, expanding the list of acceptable collateral, expanding the list of eligible institutions, and even helping broker the JPM-BS deal and to top it even being ready to accept $29B losses and being a claimant on the residual value of the deal). These are breathtaking developments. Again I am not making normative judgment but simply noting what CBs have done even in the post-Volcker era. The still larger point is that the CBs are extremely flexible both with regards to objectives and instruments. While the talk and even the practice of rule based policy making and specifically targeting inflation is fine in academia and in "normal" times, when push comes to shove CBs will and have gone beyond controlling inflation. 4. The central empirical fact of modern monetary economics is: a shift in central banks towards de facto inflation targeting or de jure inflation targeting. In the US, it's de facto. In Europe and the UK and a few other places, it's de jure. But all over the world, you see this shift. Clarida, Gali and Gertler measure the inflation and unemployment coefficients in Taylor rules and find a sharp difference in the modern period. Their approach has spawned a literature on these questions with broadly similar results. So in my mind, there is one empirical fact: the behaviour of central banks changed sharply away from chasing other objectives to chasing inflation. As I said before, inflation targeting does not mean that the output coefficient of the taylor rule goes to zero. So I am not expecting central banks to be inflation nutters'. I do expect strong coefficients of above 1 on inflation, coefficients of below 1 on output, and no importance for the exchange rate once these two are controlled for. Post 1992 there has been negligible currency trading in mature market economies. Central banks of mature market economies today care about inflation and not the exchange rate. There is not a lot of distance between true blue academic monetary economics and the practise of monetary policy in mature market economies. Yes, the two are not the same. But they are not poles apart. There are differences in matters of detail. At the big picture, there is no gap in what is proposed in academics and actually done in central banks. See recent works by Mishkin and Blinder on this subject. Also see the John Taylor paper "30 years...". The new strategems of the US Fed, designed to get around a faltering monetary policy transmission, are not inconsistent with inflation targeting, familiar coefficients on a taylor rule, or the taylor principle. The mechanics is new (as it should be), the goal is the same. 5. Hello I saw you today on CNBC-TV18. You look totally different from the photo given in blog. Your view has always impressed me. Very good article. 6. 1.Personally, I do not see drastic capital inflows in India specifically because of the interest rate differential. 2.How can India import the global inflation by maintaining the dollar peg? Inflation can definitely increase in India if the Rupee is devalued for maintaining the dollar peg. 3.How will the exports sustain if the rupee is allowed to appreciate 10%? For an economist it is easy to say that you allow the rupee to appreciate by 10 %. But it is very difficult for the government regulators and central banks to solve the problems of exporters. 4.Reduction in interest rates would mean more money in the hands of corporates and more lending consumption and investment. This will reduce the differential and stop the foreign inflows but will not help domestic inflation. I would like to have your comments on the above. 7. Bhavik, > 1.Personally, I do not see drastic capital inflows in India specifically because of the interest rate differential. Look back at 2007. In August, capital controls against ECB came in. In October, capital controls against PN came in. After that, world risk conditions degraded. This normally hurts capital flows to emerging markets. What happened after October on implementation of the rupee-dollar pegged exchange rate? Things got worse! RBI's intervention got bigger, not smaller. How does one explain this? I think the enlargements of the interest rate differential was a critical part of this story. > 2.How can India import the global inflation by maintaining the dollar peg? Inflation can definitely increase in India if the Rupee is devalued for maintaining the dollar peg. The USD is shrinking. Sellers of goods globally are rebelling and raising the USD price of their products. If we fix to Rs.40 per dollar, then higher dollar prices show up in India, both for direct imports, and for the large number of products where there is import parity pricing'. To undo this effect, we need an INR appreciation. > 3.How will the exports sustain if the rupee is allowed to appreciate 10%? For an economist it is easy to say that you allow the rupee to appreciate by 10 %. But it is very difficult for the government regulators and central banks to solve the problems of exporters. Look at the experience of 2007. There was an INR appreciation from 44 to 40. There was no big impact on exports. What is going on? Part of the story is that inputs also become cheaper when there's an appreciation. Part of the story is that exporters get smarter. In the market economy, it's always possible to identify gainers and losers from price changes. So does that mean price fluctuations should not take place? If potato prices go up, it's bad for buyers of potatos and if potato prices go down it's bad for sellers for potatos. So does that mean a government has to get into the act? > 4.Reduction in interest rates would mean more money in the hands of corporates and more lending consumption and investment. This will reduce the differential and stop the foreign inflows but will not help domestic inflation. As long as we run a pegged exchange rate, we will see unruly problems with capital flows if there is a large interest rate differential. I'm the first person to say we should NOT be pegging to the dollar. But if we are, then we should have the good sense to see that our interest rates have to then be in line with the US. Yes, lower interest rates will push inflation UP. My claim is that the monetary policy transmission is weak so this is a small effect, and is overcome by the disinflationary impact of an INR appreciation. Right now monetary policy is a mess with both the interest rate and the exchange rate in the wrong places. I'm saying that we should put both into sensible places. 8. "In all mature market economies, the task of controlling inflation - and only the task of controlling inflation - is placed with the central bank" You don't justify this statement either in your article or your responses to ecothinker above. There is no generic Central bank mandate for "mature market economies". The ECB's mandate probably makes it more of an inflation hawk than the Fed or the BoE...primarily because of the political compusions when the EU was formed. Had these central banks limited themselves to being guardian of price stabilty, the consequences of the ongoing market deleverage would have been far worse! (Think Libor rate without liquidity injections, Bear Stearns, Northern Rock). So to repeat ecothinker's point...your assertion - in mature economies, a central banks' sole responsibility is controlling inflation - is patently wrong. The Fed's actions in recent times prove that beyond any doubt. (Arguably...if the Fed had realised its broader role earlier, the markets would have been in a better shape.) 9. Could someone wake up Ajay Shah from the deep slumber he has started in 1980. He is the only economist who still feels, "From Paul Volcker's time onwards, the US Fed has been a de facto inflation targeting central bank - " He is the only soul who feels the below are for inflation targeting. Bear Stearns Rescue TAF TSLF ajay, you have been grossly wrong with lot of details w.r.to USD/INR movement of late. Better have a line with a trader to understand what is happening your reserve growth articles are also grossly wrong. 10. Hello Sir, I've a very elementary doubt. Could you explain how a larger interest rate differential has spawned a huge increase in capital inflows; especially when most of the inflows are in the equity market? Equity inflows (as opposed to Debt) must be independent of the interest rate differential rt? Thanks in advance :) 11. shrikanth,$110 bn flowed into India last year. I guess only 25 bn is for equity markets

12. This comment relates to the BL article you refer to (that article is full of holes but I restrict myself to the extracts on your blog).

The authors start with a strange proposition that since the "dollar is fast losing its strength" one should use the Euro. This is odd for since the mirror image of dollar weakness is the Euro's strength how does that make the latter more suitable?

The point is that neither the Euro nor the dollar is an invariant measure of value. Nor is gold or any other commodity. Any choice is to be justified by some logic and not by the weakness or strength or a currency at a particular point of time, the way the authors seem to do.

To refresh memories, the Euro declined sharply by app. 30% from 1 Euro = $1.2 at inception (Jan. 1999) to a low of 0.82 (late 2000), then did nothing for a year, then journeyed up to 1.3 by Jan. 2005, declined to 1.2 by early 2006 and has since rallied to 1.55. Now the authors focus on the last two years forgetting the earlier history. While since 1999 the Euro may not seem to have done a lot (1.2 to 1.55) the period was marked by large movements. In fact, if one chooses to measure agricultural prices in a currency or commodity which has appreciated more against the dollar than the agricultural commodities used by the authors one can actually show declining agricultural prices. (Note also that the graphs of the various agricultural goods have different shapes and different peaks and troughs, suggesting that factors other than the exchange rates (for, e.g. supply and demand dynamics of individual commodities) are pretty important factors. Sugar is particularly interesting - its prices have essentially halved in the past two year, in an time of rising prices) Finally, Dr Shah you offer no explanation or mechanism as to how dollar weakness leads to rising international prices. Most international prices are denominated in dollars and then converted into other currencies. Are you suggesting that had prices been denominated in say, Euros we won't have had price rises. If so, wouldn't that be an example of denomination fallacy? What if prices had been denominated in say the Zimbabwean dollar, or pork bellies or sea shells, instead? 13. > Most international prices are > denominated in dollars and then > converted into other currencies. > Are you suggesting that had prices > been denominated in say, Euros we > won't have had price rises. If so, > wouldn't that be an example of > denomination fallacy? What if > prices had been denominated in say > the Zimbabwean dollar, or pork > bellies or sea shells, instead? You are a producer of widgets in (say) Eurozone. You are writing invoices to your customers expressed in USD. The USD took a 30% fall in the last five years or an average of 6% per year. It is denomination fallacy to think that the producer will ignore this drop in the USD. In the long run, there is no money illusion. My claim is that the producer understands that the USD is a shrinking numeraire, and on average, raises his prices (measured in USD) by 30% to compensate himself for the reduced value of the USD. I am not saying this is the only factor at work in thinking about global inflation in the last five years. But it is surely one factor that is at work. And, at an Indian policy level, this diagnosis does not affect the proposition that an INR appreciation has a deflationary impact. INR appreciation has a deflationary impact regardless of what be the source of inflation. INR appreciation makes foreign goods, and local transactions that are priced at import parity pricing owing to the threat of imports, cheaper. These effects hold regardless of your theory about how inflation came about. 14. You claim that the European widget producer raises USD price to offset Euro currency appreciation vis-a-vis the USD. Well, that is what the widget producer would like to do. Does it actually happen? Can he pull it off? You take desirability as synonymous with ability. (One must a/c for the structure of the industry, competitive pressures from manufacturers in the US and other non-Euro zone countries. There is some empirical work to suggest that exporters take a hit on margins to keep sales going.) However, what is truly important to note in the present context that most of the price increases (globally) in the past few years have been in non-manufactured (excluding metal) goods i.e. in minerals including oil, ores, metals and agricultural commodities, the last especially during the last year or so. Presently the supply and demand elasticities are low which is a relevant factor. We are dealing with the short run here. The terms of trade have thus shifted in favour of primary (broadly defined) and against secondary producers. However, this need not necessarily lead to an absolute decline in the income of the secondary producers. Strong global growth for manufactured goods, in the absence of wage pressures can lead to higher capacity utilization, without even a reduction in margins (though that may happen too) even if material cost percentage rises. Several things still puzzle me: 1) Countries such as India, China, Brazil and Russia have substantially higher inflation than the US in spite of having their currencies appreciate against the USD. Is the structure of economies that different? Are price indices so very different? 2) US inflation while having risen is still far below these countries and even below what an incorporation of currency impact would suggest. Why is that the US not experiencing very high rates of inflation with a currency down 30 %? Surely, a paradox of sorts? 3) All past episodes of USD weaknesses have not quite coincided with commodity prices rising. Why so now? 15. ecothinker makes a very valid point, one that really makes you wonder about the intensity of price increases in nations such as US vis-a-vis in say a country like China and India. However, there is one thing worth noting here - the concentration of inflation rests with nations that are causing it, all 'major' primary producers/consumers - China(8.7%), India(7%), Russia(12%), Gulf nations(7-9%),...etc. Maybe, its to do with rising income levels, and therefore increasing prosperity, among the common folk in these nations. Salaries in these nations continue to rise and so do realizations to farmers. One important fact that most of the media has missed out on is the massive appreciation in arable land in rural India. I think pple are earning well and hence consumer spending remains high, which a year ago was spent on consumer durables...but is now spent on food and other necessary household items. - taku 16. oops....one small miss. ....its the massive appreciation 'in prices of arable land". - taku. 17. The main reason why I feel about US inflation being low is that several countries have for all these years invested in the US Dollar. Dollar had the status of reserve currency. Mostly all countries FX reserves were lying with Nostro Accounts in US. US has a policy of exporting inflation to other countries. US does not absorb these investment in home country i.e. it invest in other emerging and developing countries like China and India keeping domestic inflation low. The investment absorbing capacity of developed country like US is very low so it invest in other countries and other currencies. Would like everyone's comments on this...... 18. This comment has been removed by the author. 19. Now inflation is above 7% and the government is already battling out. The measure mr ajay is suggesting " a 10% appreciation or a a rise\fall in interest rates " becomes quite unconvincing without explaining the basic economics attached. Inflation is a monetary phenomenon is the first thing that comes up on mind though many of us accepts currently inflation is spiralling because of global economic variables. Globalization has to pay price for that matter.Few days back after reading an article at economic times there can be no reason to discard the growing crude oil prices at$132 a barrel a reason furthe spilling inflation.

Lets see economics. Inflation rises when there is increase in money supply in an economy.why the current money supply is increasing. There can be two factors domestic and external.People are drawing out money from bonds with domestic interest rates proving unattractive.Economics says raise the curtain.

Before reaching to any conclusions there are external forces also causing an increase in money supply. Citing the example of US slowdown with falling interest rates making it the vindicated destination for inflows. Fed is reducing rates to curb the slowdown or to "postpone" recession. So that rate of return remains positive and the capitlists keeps on injecting money so that M-C-M' cycle does not breaks.My honest suggestion to bernanke economic crisis is inevitable.Since we are concerned about ourselves its better if we leave bernanke alone for the point of time.Therefore, India becoming an lucrative destination with interest rates more than 8%. The foriegn inflows are increasing the money supply and making it tougher for RBI to control.As a result of above the rupee is appreciating and hurting exports.

To curb the inflation resulting from domestic factors principle causes being the price rice. An increase in interest rate does help in reducing money supply but will lead to further increase in inflows . Our currency will further appreciate and thus hurting our exports more . At the end of the day to support our loss ridden domestic firms will put pressure on monetary policy and cause the domestic interest rates to fall (the same way the fed is cutting rates) making it an unattractive destination and thus curbs inflation. In this process what we can conclude is that its effects would be minimal as there are fair enough reasons to support this view. The reasons being -

India has an incremental capital output ratio of four and a domestic savings rate of 32-33%, which implies that in order to achieve a sustained growth rate of 10%, dependence on foreign capital would tend to come down in the days to come. Further, India has the least exposure to the US among all Asian countries and is therefore a relative safe haven among Asian markets, most of which have a strong exposure to US consumption.

Do support me , if my comment is making sense..do reply

20. i think inflation would not have occurred if there would not have with us any rbi,wats ur say. ginny.1987@gmail.com

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