Tuesday, August 18, 2009

Implications of a bad monsoon for monetary policy

The progress of the 2009 monsoon seems to be 29% below normal. This may be adversely affecting food prices. In the latest available data, inflation based on CPI-IW has surged back to values near 10%. (This is the three-month moving average of the rate of change of seasonally adjusted CPI-IW).

Ila Patnaik has an article in Indian Express analysing the implications of this situation for monetary policy.

India really needs an `inflation report' institution.

1. I would agree with the thrust, but the article is poorly argued and has several conceptual flaws:

1. "The real interest rate, measured by the nominal interest rate at which companies can borrow minus the inflation relevant for the manufacturing sector, has risen sharply in recent months."

My comments: Real rates are an ex-ante concept, not an expost concept.

2. "RBI should be cutting rates if it looks at forecasted output growth"

My comments: Forecasted output growth has relevance for monetary policy only in the context of potential growth - a concept not easy to define for an economy such as India .

3. "Ironically, earlier, in 2006-07, when the economy was overheating, output growth was high and investment rising sharply, inflation targeting would have meant that instead of focussing on keeping net external demand high, by keeping exports cheap and imports expensive, the RBI would have welcomed rupee appreciation."

My comments: This solution fails to account for how exchange rate expectations would have responded to a sharp INR appreciation. Potentially, this would have increased inflows.

4. "I argue below that no amount of raising rates will bring vegetable prices down. Monetary policy, when effective, can impact prices and output 4 to 6 quarters later. The last thing to expect from it is impact on seasonally volatile prices in specific sectors.

The mechanism through which interest rates impact prices is by changing demand."

My comments: This point completely misses the role of inflation expectations.

The main task of monetary policy is to anchor long-term inflation expectations.

Any level of output gap can be associated with any level of inflation based on where inflation expectations are.

Clearly, to the extent persistently high headline inflation - whatever the source- could impact inflation expectations, central banks in some cases may have to react to supply shocks.

Yes, monetary policy cannot bring prices of primary goods down, but it can lower prices in other areas to keep overall inflation low.

Not that I am advocating this response right now, just bringing out a conceptual point.

2. Hi Ajay,

This article ties in well with your earlier post about needing a better policy speech. It's obvious to me that RBI needs to first, have better defined objectives and second, do a better job of explaining those objectives and related policy actions.

Then the question becomes: Whether the RBI agrees with this but doesn't want to (or cannot) change their current ways or that they just have a different philosophy on central banking.

3. Could you write an article (or point to something existing) that describes how inflation is actually calculated, what is it based on, and why in spite of -ve inflation, the prices keep rising?

4. There are many variants to the theme of political influences on monetary policy; this is the standard one

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