Given unknown base effects and long & variable lags, can a monetary official ever get policy action wrong?
Since my article a month ago (The Financial Express, August 26, 2015, Why inflation fell), headline CPI data for August was released and to the surprise of many, it registered a second consecutive 3.6-3.7 % headline inflation print.
As we await the RBI decision on monetary policy on September 29, it is important that we have a correct handle on what has caused inflation to fall so rapidly. Citing an RBI study, Governor Rajan alluded to three big possible causes for the CPI inflation decline: “the good inflation news follows from a combination of good food management by the government, good luck because of external factors such as lower crude prices, and monetary policy”.
In this article, I want to look at the individual contributions of the three causes of inflation decline over the last three years. But how do we measure inflation? There are a plethora of CPI inflation indices—headline, food, ex-food, core, core-core etc. For the purpose of disentangling the causes according to Rajan’s formulation, let me offer an additional index—basic CPI inflation or overall CPI minus inflation due to external shocks (oil) and changes in taxation.
Oil price shock is a biggie, as are the service tax increases in effect since June. The service tax increased by a rather large 13.2% (from 12.36 earlier to 14% since June 2015). This obviously has an effect on prices, and y-o-y calculations, and it would be a mistake to construe tax-induced inflation as constituting structural inflation which anyone should be worried about, especially RBI. While tax increases, ceteris paribus, decrease the fiscal deficit, RBI (e.g, Deputy Governor Urjit Patel!), on the other hand, has been emphasising the inflationary effects of fiscal deficits for decades. I have yet to find any significant effect of fiscal deficits on inflation (it is an outcome variable, not a cause), but that can be debated on another day. The fact remains that tax increases should not be part of assessing underlying or structural inflation—just like oil price changes (declines) should also be eliminated while discussing structural inflation.
My suggested index of “core” inflation, or basic inflation, is the following: it is inflation excluding food (weight = 45.86 %), excluding fuel and light (mostly government-administered prices for kerosene, PDS, electricity etc.; weight = 6.84 %), excluding consumer prices of petrol and diesel (in transport and communication; weight = 2.19 %), and excluding CPI for “pan, tobacco and intoxicants” (weight = 2.38 %). The reason for excluding CPI for tobacco,etc, is because this sector is also hugely affected by tax changes. Hence, CPI basic includes housing, education, health, clothing, footwear, etc. The total weight for these items: 42.73 %, and almost equal to that of food, 45.86 %. Basic and food inflation together constitute the “true” index of CPI inflation.
The trend in these two constituents of inflation—basic and food—can help assess the contribution of the three Rajan factors to the decline in Indian CPI inflation: food management, oil prices, and monetary policy. After averaging 9.8 % for the previous seven years (2007-2013), headline CPI inflation fell to 3.7 % for two successive months, July and August 2015. There is little doubt that CPI inflation has fallen, and fallen sharply.
While the price of oil (and commodity prices for metals, etc) does affect the WPI, the only direct effect of the decline in the international price of oil on the CPI is via the index component that has already been excluded from the basic CPI. In any case, petrol prices for the CPI are only down 11 % from last August despite halving of the price of crude oil since then.
The real story of Indian inflation decline is that of food; in turn, this has been caused by the (lagged) increase in the minimum support price (MSP) of food. The pace of MSP increases started declining from the setting of the winter crop MSP in August 2012. The wheat MSP was announced on August 3, 2012; it was only 5.1 %, compared to the 14.7 % increase of a year earlier. Interestingly, the MSP for rice (paddy) does not show this sharp decline—indeed, at 15.7 % and announced on June 14, 2012, it was almost double the 8% increase of a year earlier!
So, what happened in the UPA during these two months to cause such a radical shift in the MSP policy? When economic historians write about the great inflation decline in India, they will have to credit P Chidambaram, who assumed the role of finance minister again in July 2012.
Every MSP policy action, since the “pioneering” Chidambaram initiative of August 2012, has led to MSPs, and food prices, declining in India. The average MSP increase in 2013 was 6 %, and 2.4 % in 2014, and likely to be less than 3 % in 2015 (once MSP for the rabi crop is announced). Food prices have declined from a 12% and 12.6% rate, in 2012 and 2013, to 8.6% and 2.9% rate, in 2014 and 2015, respectively.
It is hard to argue that monetary policy had anything to do with this “supply-side” decline. But Governor Rajan may have had something to do with Chidambaram’s initiative—he formally joined Chidambaram’s ministry just nine days after the “historic” MSP decision. There is no way of knowing whether Rajan was consulted by Chidambaram—but what one does know is that in his last few policy statements, Governor Rajan has been emphatic about the need for MSP prices to be contained in order to contain headline inflation!
We cannot attribute monetary policy to food price declines, but we can attribute at least some of the basic inflation decline to actions of RBI. Basic inflation declined from 8.1% and 8.9% level in 2012 and 2013, respectively, to 4.6% in August 2015. Note that service tax increase post-May 2015 possibly account for about 0.6 percentage points of the decline in basic inflation; i.e., basic inflation is at present running at about a 4% rate.
We can now summarise the role played by Rajan’s three factors in accounting for the great Indian inflation decline. Overall, CPI has declined by 6.7 percentage points since August 2013; true CPI inflation has declined by 7.1 percentage points. Food price decline has been 9.7 percentage points and this has contributed to almost 75% of the decline in true CPI; the maximum share of monetary policy is 25% and zero share of oil price in the true CPI decline.
Note that we have not mentioned base effects even once; nor have we mentioned inflation expectations. Base effects do not enter into the above calculation, they cannot for a four-year period. Remember that “base effects” is one of the three most important self-defence tools in a monetary policy maker’s arsenal. The other two are: monetary policy acts with long and variable lags; and, lest we forget, monetary policy needs to anchor all important inflation expectations. Can any monetary official, anywhere, ever make a mistake!
The author is chairman, Oxus Investments, and senior India analyst, The Observatory Group, a New York-based macro-policy advisory group