## Saturday, May 24, 2008

### Understanding the inflation in emerging markets

A lot is said about inflation being a global problem today. But when you glance at the front page of the Bank of England website, they report CPI inflation of 3% as compared with an inflation target of 2%. This is not so bad when compared with the 8% inflation that we see in India and China. The Economist has a good article interpreting the bad inflation that has sprung up in third world countries. Their main argument is that these countries are making the same mistakes in monetary policy formulation which gave high inflation in industrial countries in the 1970s. Economists in industrial countries, and then central banks in industrial countries, digested the lessons of these experiences, but this learning did not happen in (say) India.

One simple way to see how monetary policy has gone wrong is the `Taylor principle'. When there is a 100 bps rise in inflationary expectations, if the policy rate does not rise by atleast 100 bps, then the real rate goes down. Under such a monetary policy regime, positive inflation shocks are expansionary (and vice versa). Monetary policy is destabilising. This is a key channel through which a central bank which is not primarily focused on inflation ends up exacerbating the business cycle.

To review the recent Indian experience, yoy CPI inflation was 5.5% and WPI inflation was 4% in late 2007. Both have accelerated by 200-300 bps. But the short rate has not budged. In other words, the real rate has gone down by 200-300 bps. This violates the Taylor principle: when combating inflation, you surely do not want the real rate to drop sharply.

You might like to read this on the Taylor Principle.

1. Am I reading this right? I thought you were one of the many criticizing Dr. Reddy for not cutting rates when US Fed cut rates early in the year several times.

BTW, Fed funds rate is 100bps below CPI too...looks it hasn't learned much either - although it seems to say no more cuts...

2. My opinions fall into two parts.

If - and only if - we are going to have a de facto pegged exchange rate, then we lose monetary policy autonomy. It is not possible, then, to have an interest rate differential of 500 bps against the US. By doing this in recent months, RBI set the stage for the big mess on inflation. Both China and India got themselves into a huge mess by trying to fix the exchange rate to the USD, violating the Taylor principle, having real rates that were too low, etc.

If we could shoot for first best, I'd be the first to say that the central bank should be focused on inflation and not exchange rate. If this is the scenario of interest, then we'd need a real rate of 300-500 bps to slow down this inflation, which would be a worthy cause. This is the right thing to do, but first you'd have to do a RBI reform.

3. While the US fed funds rate is low, remember that all said and done, the US has not ignited a large inflation. India has 8% inflation while not adjusting prices of fertilisers, fuel, etc. The US Fed still has very strong inflation-fighting credentials. RBI has very strong exchange-rate pegging credentials.

4. But is the analysis indepedent of the reason for inflation. As I understand at this time inflation is due to supply constraint and not because of increase in demand.

5. Sir,

Re : The Economist has a good article interpreting the bad inflation that has sprung up in third world countries

Thank you for the link, I think it puts things in a very clear perspective. I, too, wondered at one point over the last couple of months, whether it has not been the RBI's rather 'slow' response to the developments from the Fed as well as the business cycle and growing demand in India, in the first place, which has probably led to (or perhaps intensified)the current curious situation here.Or should I say, them trying-to-be-politically-correct policymakers in India?

Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language. I delete any comment which does not contribute to the intellectual discussion about the blog article in question.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.