In the first part of this piece (FE, January 23), we had explained how the domestic monetary policy conduct is being increasingly influenced by external factors, as the Indian economy is being closely interlinked with its global counterpart. We believe that this integration may be increasingly diluting the effectiveness of domestic monetary policy actions to contain inflation. In this concluding part, we analyse this hypothesis.
Let us first start with the movements in core inflation in April 1995-December 2012 (the latest month for which data has been released). For April 1995-March 2004 (with 1993-94 as the base), the weight of core inflation/non food manufacturing was 52.2% and that of imported core was roughly 40.7%. After the weights were revised in 2004-05, and the new WPI index launched, the share of imported items were roughly 48.9%, while that of core items at 54.9% (share of imported core stood at 33%, up from 29% and that of non-imported core declined). Interestingly, while there is no unanimity or official estimate of the share of imported items in WPI, we followed the decomposition that RBI had given out in its October 2011 monetary policy announcement (for both the 1993-94 and 2004-05 WPI series).
As Graph 1 shows, core inflation that was ruling high at more than 12% in April 1995, turned negative in January 1997, on the back of a significant decline in imported inflation and a de-growth in domestic core inflation (June 1996-May 1997). The trends in core inflation suggest that it touched a peak in January 2001, July 2004, August 2008 and November 2011. However, more importantly, in the run-up to all such cases, the contribution of imported core was becoming more significant, driven by a flare-up in oil prices, or rupee exchange rate. The movements in inflation were becoming more influenced by external factors, on which RBI had little control.
Apart from the trends in imported core, the trends in domestic core deserve a special mention. Domestic core prices were getting increasingly aligned with the international trends in commodity prices (see Graph 2) with the passage of time, reflecting a progressive pass-through of input costs.
For example, over the entire period (April 1995-December 2012), the correlation coefficient between the Reuters CRB Index and the non-imported core was negligible, but this increased to 0.33 (April 2004-December 2012) and further to 0.72 (April 2008-December 2012). Clearly, not only imported inflation, but even domestic core inflation was being driven by exogenous factors (gyrations in global commodity prices). It may be noted that RBI had started increasing rates from March 2010 onwards in an effort to control spiralling inflation.
Apart from international factors, there were also some domestic factors that were responsible for price increases, but that could not have been controlled by RBI. It is well-known that food prices have been at elevated levels for a long time, and given that retail inflation has a significantly higher weightage of food items, it is no wonder that retail prices are still ruling at more than 10%. In fact, if we look at core CPI inflation (excluding food & fuel) it has been trending downwards from June 2012 and is currently at 8.1% (overall CPI at 10.6%).
The most important reason for retail numbers being significantly higher than WPI could possibly be because of the transaction cost of food items that gets embedded in retail price through inflationary expectations. Transaction costs include transportation, intermediation,electricity for cold storages, mandi commission charges, etc. FICCI research shows that if the farm gate price for onion is R100, then the retail price could be R121.4 plus the mark-up at the retail level! Clearly, the increased retail prices over a long period of time may be attributed to a large extent on supply bottlenecks, on which the central bank may not have any control.
Also, historical trends suggest that the last time retail inflation numbers were below 5%, was in January 2006, exactly six years ago. If we assume that RBI still looks at a 5% acceptable inflation rate even for food inflation, then purely going by retail inflation numbers will not justify any rate cut any time in the near future.
Interestingly, we also used a set of statistical tools to understand the impact of an interest rate increase on output growth. We estimated Impulse Response Functions (IRFs), which are simply a set of coefficients that summarise the propagation of shocks in any of the variables across all the others over a period of time. Looking at Graph 3, the IRFs show that the rate increase impacts the output over a sufficiently longer time horizon.
RBI has been steadfast in its approach of controlling inflation over the last 3 years. Interestingly, the latest round of diesel price increase will actually help inflation rates stabilise in the long term. This also borne out by the recent trends in inflation, which is on a downward trajectory. If we recall, diesel prices were increased by a sharp R5 in September, but the inflation rate based on the WPI has declined from 8.07% in September 2012 to 7.18% in December 2012. Clearly, a staggered increase in the price of diesel will free up productive resources for efficient allocation and this will neutralise the adverse impact in short-run. RBI can join the party on January 29 with a rate reduction to improve sentiments further.
This concludes the two-part series
The author is Director, Economics & Research, Ficci. Views are personal