Column: Monetary policy irrelevant for inflation

Written by Surjit S Bhalla | Updated: Sep 13 2014, 07:09am hrs
The CPI data has just been released, and contrary to expectations, the annual rate of change (yoy) in the index was a very respectable 7.8%. This is the fourth-lowest monthly CPI number since February 2008 when a weighted average of rural and urban inflation rates registered 6%. The lowest CPI inflation since then was in June this year7.2%. That is 78 months of data since February 2008 and two of the four lowest inflation months have occurred in the last three months.

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RBI has been fighting the good fight against inflation and many would be tempted to conclude that monetary policy is working towards reducing inflation and inflationary expectations. There have been three clear policy initiatives outlined by RBI: the need to anchor inflationary expectations, the need to keep policy rates high and the need to implement inflation targeting. Perhaps all three measures have worked to reduce inflationor, perhaps as documented below, none of these three initiatives have had any role in lowering inflation.

Tight monetary policy has as much to do with Indian inflation as it has to do with India's magnificent loss to England in the recently concluded Test series. In a series of articles (academic and journalistic) written over the last decade, I have attempted to document that the traditional measures of monetary and fiscal policysome version of money supply or credit growth or fiscal deficitsdo not explain, at all, the path of inflation in India. Econometric models based on these variables, no matter how manipulated, explain zilch of Indian inflation.

Two variables are key to explaining Indian inflation. First, and obviously, international inflation plays an important role. However, the model that Indian inflation is some function of international inflation has broken down over the last decade. So what does explain Indian inflation, not only for the last 10 years but for the last 40 years The policy of minimum support prices (MSP) for food determined by politicians at the Centre. MSP inflation explains a very large fraction of the variance in CPI inflation around a 5% mean.

The Indian inflation model is a one-variable one-trick pony: CPI inflation is explained by MSP inflation of the previous year. The model simply says that the predicted inflation in any year is 5.1% plus a third of the lagged MSP inflation. That is it. No repo rates, no real interest rates, no money supply growth, no fiscal deficits, no nothing else. The model is estimated from 1978 (the policy of MSP came into being in 1975) till 2004. This end year gives one a decade of out-of-sample prediction as reported in the table.

A lot has happened in India, and the world, since 2004the last year for which inflation and MSP data has been used to determine the model. The average error of the model 2004-14 is only 0.25%, with the largest over-prediction in 2009 (actual 10.9%, prediction 13.2%) and the largest under-prediction being in 2010 (actual 11.9%, prediction 8.2%). The fact that the large errors follow each other is a very positive aspect of the model. Excluding these two large errors, the average prediction error is a low 0.1%, with a range of (-)1.6% to 2%. Such accuracy is not a function of luck, or randomness.

Apart from accuracy, the model has strong implications for RBI's repo policy aimed at reducing inflation. Since May 2013, the repo rate has increased from 7.25% to 8% while GDP growth has plumbed to multi-decade lows. But inflation has declined by 200 basis pointsfrom around 9.5% to around 7.5%. Before (the monetarist) one gets carried away by saying we told you so, note that the repo rate increased from 6.25% in end-2010 to 8.5% end-2011; this not only had a zero effect on inflation but actually was correlated with increasing inflation!

If not deficient demand, and not tight money, then why is inflation down by over 200 basis points in 2014 It is because of MSP, stupid. In 2012, MSP was increased by 16.2%, so predicted (and actual) inflation in 2013 was close to 10.5%. In 2013, MSP increase was 6%; and both predicted and actual inflation close to 7%. Bulls eye (for details, see table).

RBI governor Raghuram Rajan has a CPI inflation target for end-December 2014 at 8% and end-December 2015 at 6%. The MSP model says that both targets will easily be met with the average inflation for 2015 predicted to be 5.8%. Given that inflation rates are falling from lofty heights, it is likely that December 2015 inflation will be closer to 5% rather than 6%.

I don't know if more documentation or confirmation is necessary to verify that monetary policy has played a zero role in either its rise to 10%-plus for six years or its predicted fall to around 5% by end-2015. A friendly challenge is offered to RBI, and monetarists (hawks and doves), to either prove where my analysis is wrong, or even suspectOR to offer a monetarist, inflation targeting, anchoring inflation expectations, real interest rates model to explain any of the CPI inflation over the last decade. A fair duel deal

And yesan additional request to RBI. Please junk your inflation expectations survey before it causes more damage to your enviable reputation. Making repo policy on the basis of the inflationary expectations survey is exactly the same as making policy according to a random noise generator. The latest June 2014 survey has the following gems, and I quote from the RBI report: Current perceived median inflation rate is 13.3%, whereas median inflation expectations are 14% for three-month ahead period and 15% for one-year ahead period; and the proportion of respondents expecting double-digit inflation in next three-month period have declined marginally to about 72%. Since January 2011 (43 months), the maximum yoy inflation was 12%, and the average was 9.8%. Over the last 24 months, average inflation has been 9.5% and maximum inflation of 11.2%. Pure junk was never defined better than the results of the RBI expectations survey, the very same that RBI uses for information on anchoring inflationary expectations.

The simple point is that inflation in India is a structural problem, and one whose structure is not determined by excess demand, or by deficient supply, or by mis-measured inflationary expectations but what the political arm of the government decides to do about winning elections and consequent vote-priming of rich farmers. We have just seen the disastrous consequences of such a policy for the political side of the equation. Food is 50% of the CPI, so aiming monetary policy at food inflation is the same as raising interest rates to force the Saudis to cut the price of oil.

The author is chairman, Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla