Screen MPC contenders on the basis of how they explain the past determinants and the future trend of inflation
While it is generally accepted that CPI inflation has come down in India, there is still considerable debate as to (i) the causes of this decline and (ii) whether this decline is sustainable. The answer to these two questions is extremely important for gauging the future course of monetary policy. Governor Raghuram Rajan approvingly cited a very recent RBI study (What is responsible for India’s sharp disinflation) on the two questions. This study, he stated, had three important conclusions: “first, that 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, including the new framework. We believe this is a fair view of the disinflation so far, entirely uninfluenced by the fact that two of the three authors are from RBI (Fears on inflation still high, August 25, 2015, Business Standard).
One of the three authors is Sajjid Chinoy who, in a Mint article titled Making sense of inflation in India (August 24), discounted the efficacy of good food management by concluding that “The variation in MSPs is largely mimicking world food prices” and that “a secular decline of global food inflation over the last year has likely had an important impact on India’s food inflation”. So, what brought inflation down, if not MSPs, according to Chinoy? Why, oil and international food inflation, of course.
As readers of this column know, I have talked (since July 2011) about the importance of government-administered minimum support prices (MSPs) for food, being almost the determinant of CPI inflation in India. No other variable (money supply growth, fiscal deficits, output gap etc.) has any explanatory power in explaining Indian inflation from the late 1970s to the present. However, there is an additional important determinant—the effect of international inflation as proxied by the median inflation rate in emerging economies. However, this ceased to be relevant for the Sonia Gandhi-inspired MSP explosion during 2004-2013, i.e., international inflation effects were swamped (eliminated!) by the extraordinarily high MSPs engineered by the Gandhi-led UPA (no doubt in the mistaken belief that such increases would yield a majority of seats in Parliament).
What effect did the oil price decline have on inflation, as suggested by both Dr. Rajan and Chinoy? Recent history provides for a “natural” experiment about policy choices and determinants. In June 2008, oil price reached $134/barrel and y-o-y CPI inflation was 8.3%. A year later, in June 2009, oil collapsed to $70 and CPI inflation increased by 2.2 percentage points to 10.5%. Compare and contrast this with what happened in the recent one-year period, June 2014-June 2015. Oil prices declined from $105 to $60. But, in contrast to 2008-09, CPI inflation fell by 1.4 percentage points from 6.8% to 5.4% (and by 3 percentage points to 3.8% in July). So, if oil prices are responsible for the decline in inflation in India 2014-15, why did inflation decline not happen in 2008-09? One major explanation: (lagged) MSP increased by 15.9% in 2008 and 20.9% in 2009; in contrast, (lagged) MSP increased by 5% in 2013 and 1.8% in 2014.
What about international food prices and CPI inflation? Here, too, the same story as oil. In 2008-09, international food prices fell by 23%, but domestic food price inflation increased from 10.5% to 12.2%. In contrast in 2014-15, international prices fell by 24 %, and food inflation declined from 7.3% to 5.7%.
These data do not lend much support to Chinoy’s contention that the real influence on CPI inflation is international food inflation. When several explanatory variables are contenders for being a determinant, the standard procedure is to run a “horse race” between them. In such a race, (lagged) international food or cereal inflation lags far behind as a determinant—indeed, it is completely insignificant and to add insult to injury, of very low magnitude! However, lagged MSP inflation remains a star determinant and with a healthy magnitude—each 1%-increase in lagged MSP leads to 0.4% increase in CPI.
Of the three “determinants” mentioned by Rajan, one remains to be evaluated: monetary policy framework as being (partly) responsible for the decline in inflation. Inflation targeting framework is not yet in place, though the tabling of the Urjit Patel committee report is very coincidental with the beginning of the decline in inflation. It is hard to believe that this correlation is anything but that; in addition, MSP increase of only 5% in 2013 may have been an important contributor to the decline in inflation which started in 2014.
So, what has determined Indian inflation to date? Mostly MSP; going forward, it is very likely that MSP inflation will cease to play an important role in Indian inflation. Why? Because the country has learnt about the inherent dangers of populist policies engineered by Sonia Gandhi and the UPA government. It will be a case of ‘never again’. So what will determine domestic inflation? RBI interest rate policy?
When was the last time RBI rate policy determined inflation in India? This is not a rhetorical question, it is one that deserves an answer. Growth, jobs, poverty reduction, and human welfare is at stake; so, a glib answer is not desirable. The simple fact is that the world has changed, and radically so, from when most of us studied monetary economics. Just look at what has happened in the rest of the world, and happened for the last 20 years and continuing. Most major economies have reduced policy rates to zero and inflation has declined. It is high time the monetarists woke up and smelt the cheap coffee or anything else they are fond of.
Deflation is likely to soon become a major concern in India. My preliminary estimates suggest that y-o-y GDP deflator inflation in India, for the April-June quarter, will be in negative territory. By the way, there is a flipside of negative or low deflator inflation to GDP growth as well—don’t be surprised if y-o-y growth is closer to 9 % than the 7 % widely being predicted by moody experts.
Very soon the search process for the monetary policy committee (MPC) will begin. I suggest that RBI screen each contender for the MPC with this question—how do you explain the past determinants of inflation in India, and how do you explain the future trend?
The author is contributing editor, The Financial Express, and senior India analyst, The Observatory Group, a New York-based policy advisory group