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Wednesday, June 06, 2007

Combating inflation

The rupee appreciation, of roughly 10% from 15 March to 6 April, has triggered a nice decline in WPI inflation. I have an article Combating inflation in Business Standard on understanding the inflation situation. Seldom in economics does reality throw up such an uncluttered demonstration of an idea.

The discussion on this blog entry offers many objections to my story:

  1. It was a `base effect'
  2. Prices did not go down - only rates of year on year growth of the WPI went down; therefore my explanation is wrong
  3. Maybe the supply side interventions of the government are getting through; maybe it is these which managed to bring inflation under control.

Let me start with the supply side interventions of the government - what I term `1970s economics' in the article. These have been going strong for a long time, before the rupee appreciation of 15 March. The documents released by the Ministry of Finance in February 2007 have a long catalog of things that were done in the previous year, in trying to attack one market after another: all these interventions were well in place before the INR appreciation. The graph in the BS article shows that none of this worked; it was the inappropriate use of policies that worked in an old India that are out of touch with an India which is a trillion dollar market economy.

As for the distinction between prices and yoy inflation, we know that in all countries, inflation has persistence. Once the inflationary fires are burning, they have a momentum of their own, since inflation creeps into the expectations of economic agents. So the default setting is that high yoy inflation is followed by high yoy inflation. The INR appreciation affected the prices of those goods which are priced by import parity pricing. For those goods, there has been an impact on prices, and I would imagine that for some of those goods there has even been a decline in prices in sympathy with a 10% change in the rupee. But these goods only account for a part of the WPI basket. Putting things together, we see continued inflation, though at a lower rate.

It's the only thing you could have expected. Nowhere in the world does inflation, which is rooted in the expectations of economic agents, stop suddenly and turn into deflation.

Finally, to `base effects', which seem to be popular amongst the folks in securities firms writing analyst reports about India. I'm a skeptic on ascribing an important role to `base effects'. They are a cop-out of economic analysis, for you say nothing when you say "there is a base effect". What is really interesting about the rupee appreciation is that it gave a turning point on the WPI series, exactly as predicted by the logic of import parity pricing. `Base effect' reasoning is devoid of such strength; it wouldn't give you an insight into turning points. The only situation where a base effect is important is where there is a big change in an administered price. That would kick up the WPI in a certain week in one year but might be relatively benign in the same week of the next year. There is no reason for expecting a base effect with WPI manufacturing. And, the effect I am describing in the BS article (that INR appreciation broke the inflation spiral) is stronger, not weaker, with WPI manufacturing.

Let's look at the evidence for WPI overall (my case is even stronger with WPI manufacturing).

The graph superposes the latest 52 points of yoy WPI inflation (overall) and the previous 52 points - i.e. the identical weeks of the previous year. The latest year happens to be the upper curve. Look at the features:

  • Early in the previous year, there was a powerful and sudden rise of the WPI from week 15 to week 20 by 150 bps. There was no "base effect" in the next year - WPI just kept accelerating without regard for the previous year.
  • Similarly, the drop in WPI from week 0 to week 15 in the previous year didn't generate a rise in this year.
  • If the claim of the "base effects" people is that the fluctuations of one year are undone in the next, then the two curves should be mirror images. They are not.
  • Then we move forward to the first vertical red line, which is 15 March, the date from which the INR appreciation began until the next vertical line where there was a sharp inflation acceleration in the previous year. In the period in between the two red lines, there was no base effect. Last year's inflation was flat at 4%, and in the current year, inflation dropped by 100 bps.
  • That leaves the last 50 bps of the drop in inflation this year, where it's possible to say that there was an opposing (bigger) change last year. Say so if you like, but it still buys you no insight.


  1. I wish to restrict myself to your point about currency appreciation helping cool inflation.

    In the relevant period (mid-March to mid-May 2007) it is the rate of inflation that has come down not the level of prices. The distinction is critical as in the corresponding period in 2006 prices were rising. So one could attribute the decline in inflation merely to this higher base effect.

    Of course, you can argue that prices would have risen in 2007 in the absence of currency appreciation. However, it is something that you have neither discussed nor demonstrated in your article.

    So at this stage one can’t quite accept your argument and it seems to be a good example of correlation masquerading as causation.

    Readers may want to check out the numbers for themselves at

  2. shah
    you must be daydreaming if you anticipate 3% inflation in 2008..
    india has become a classic sign of a overheated economy..
    the model of offshoring is on cructches.. yesterday my DSL tech service was not from india but from phillipines and it was darn good.
    trend growth in india remains 6.5%..w/ unequal economic growth, stage is set for wide spread unrest in india (witness gujjar/ mayawati ascension etc etc)

    credit cycle is turning,my freind and with fortunes of many emerging including india.


  3. i think contrary to many indian economists (wannabes), indian rupee will fall to ~RS 60 to a dollar in 2-3 yrs.

  4. You are absolutely right that base effects have no explanatory power and are devoid of insight. (The expression base effect itself is unfortunate but has the advantage of brevity and is understood widely). They can’t show any consistent pattern as you have demonstrated in your revised post. They are, however, a good starting point and a useful exposition device.

    In this particular case it could be used to make the point that the decline in inflation is seen as a result of near-stagnancy in prices in the March-May 2007 period while they rose in the same period last year. In fact inflation would have eased this year even if prices had risen moderately.

    Why am I belaboring this point? Because as soon as we can pose the inflation question as “Why have prices been stagnant since mid-March?” the perspective changes and the supposed reason - rupee appreciation - seems less convincing.

    For the question arises that if the rupee rose why did domestic prices not fall? In fact one should expect a sharp and swift adjustment as import-parity prices drop. Particularly since you argue that India is now part of a large globalized economy.

    In fact we do see such a pattern, most notably in gold where the decline in domestic prices follows the rupee movement very closely. It also helps that the international price has moved in a tight band in the relevant period. Prices of several other commodities, notably metals don’t show such a tight fit since the international prices have been more volatile but adjusting for that factor are remarkably in sync.

    In your post you do mention that prices of some goods that may form part of the WPI may have fallen. However, as I wrote in my first comment – this is not amply demonstrated in your article.

    I am not sure why you are so uncharitable to the government on supply side intervention. Reducing import duties on several commodities - wheat, pulses, edible oils and cement – reduces import parity prices and is formally equivalent to rupee appreciation though admittedly it doesn’t work across the board. Prices of these goods did not decline after duty cuts or rupee appreciation.

    One can perhaps attribute this to the tight global markets – low short-term supply elasticities – and high freight rates. So one could argue that it could have been worse if the duties had not been reduced. And for several of these goods one can’t even make the small country assumption about India.

    On the other hand prices of sugar have fallen both domestically and globally as a result of higher global production. Meanwhile it seems voluntary price caps on steel and cement may have prevented price rises in March-May 2007 period though whether it will continue is a different matter.

    Such a discussion focusing on individual commodities or groups has its uses and maybe disaggregated data is the way to go but we may lose sight of the big picture. For in any index there will always be groups and individual goods that will rise, fall or remain stagnant. We can also get good fits but the explanatory power is not always strong. Even random processes can generate well-behaved graphs.

  5. If prices determined by import parity comprise a mere 25% of the WPI a 10% rupee apprectaion should, ceteris paribus, lead to a 2.5% fall in the WPI. We are no where near that figure.

  6. You are right in saying that I shouldn't lump cutting tariffs with the other `supply side interventions'. Cutting tariffs genuinely affects domestic prices. In my rough assessment, these changes made were insignificant on the scale of the full WPI, though they were certainly in the right direction. (And, it makes sense for government to seize the moment and cut tariffs).

    I don't like to look at specific commodities when understanding overall inflation because inflation is ultimately a macroeconomic phenomenon. There are stories at the level of each commodities, and I believe that when you think about overall prices, they cancel out. To understand macroeconomic phenomena, one has to offer macroeconomic explanations.

    Suppose we make your calculation about a "first round" effect of a 10% INR appreciation on 25% traded goods. Then the rise in WPI will be roughly 6.5% (the `momentum' of the old inflation) for 75% weightage plus US inflation of roughly 2.5% coupled with a 10% INR appreciation for the remaining 25%. This works out to : > .75*6.5 + (0.9*1.025*0.25) or 5.105625%. Hmm, lines up rather nicely again. Of course, this is a very crude "first round effect". If the footprint of import parity pricing is 25% then you would "first" get WPI overall down to 5.1, and then after that, the lowered prices of the 25% traded goods would propagate to other things.

    I have estimated a variety of vector autoregressions involving inflation and my rough estimates are that a 10% rupee appreciation gives you a 150 basis point drop in WPI overall over a 4-8 week horizon. These estimates are suspect to the extent that significant INR movements were just not observed in the historical data, thanks to the tightly managed pegged exchange rate.

  7. Read this interesting news article:

    Indian Rupee should go back to Rs 45/USD


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