Fighting inflation: then and now

Oct 25 2013, 16:35 IST
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SummaryIt would be risky for the RBI to base its monetary response upon the new inflation index, whose linkages with other macroeconomic variables are not yet understood

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.

In this light, it would be risky for RBI to base its monetary response upon the new CPI, whose linkages with other macroeconomic variables are not yet understood and when growth was as weak as 4.1% two quarters ago. The vast difference in the two inflation indicators vis-à-vis the wider economic conditions suggest caution at this point. Understandably, the central bank is chary and anxious to restore its inflation fighting credentials; it would rather err on the side of over-tightening than be lax second time round. History suggests that this time it is different.

The author is a New Delhi-based macroeconomist

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