WPI inflation throughout 2010-11, in marked departure from at least two-decade movements. Historically, RBI has set its benchmark rate well above overall WPI inflation, possibly reflecting cognizance of other price indicators, monetary aggregates, output gap and so on.
By this yardstick, it would appear that monetary tightening in 2010-11 was insufficient relative to overall inflation, output and other macro conditions. While the global financial crisis was a major shock, it is likely RBI did not adequately factor in domestic demand developments, notably, the exceptional fiscal expansion and a V-shaped recovery—GDP growth was then measured at about 8.4% in 2009-10 and 2010-11. After all, WPI-guided monetary policy decisions haven’t really been wrong before. That there might have been monetary policy errors was recently acknowledged by both former Governor D Subbarao and former deputy governor Subir Gokarn.
This is plausible, as developments from 2012 would suggest. As the chart shows, from January 2012, the repo or policy rate adjusts above headline WPI inflation, remaining so throughout 2012. GDP growth also slid to around 5% in 2012. By October 2012, WPI inflation was down to 7.3%, despite 20%-plus exchange rate depreciation from October 2011-August 2012. In April 2013, headline WPI inflation fell to 4.8%. Core-WPI inflation, the demand gauge, almost halved from 5.2% in October 2012 to 2.8% in April 2013, falling further to 1.9% in August before its recent pick-up to 2.1% in September, reflecting exchange rate and diesel prices pass-through. The GDP deflator, the broadest inflation measure, also fell to 5.6% in April-June from 7.4% the previous quarter.
The significant point from this narrative is that with appropriate interest rate adjustments in 2012, the relationship of inflation with other macroeconomic variables like output, income and employment is once again restored. The visible slowdown of industrial production, especially consumer goods, retail sales, etc. buttress this; in 2013, even rural wage growth is reported slowing. This implies that the WPI’s links with macroeconomic variables didn’t really break down in the high inflation episode, but just that monetary policy wasn’t tight enough as the twenty year long monetary history would suggest.