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Friday, March 19, 2010

RBI tightening

RBI has just raised the repo and the reverse repo rate by 25 bps. Their statement is better written when compared with what has gone before. In this post, I use our seasonally adjusted data to think about what is going on.

Output forecasts

The statement says:
In the Third Quarter Review of Monetary Policy in January 2010, the Reserve Bank had raised the CRR by 75 basis points in two stages. This reflected the growing confidence in the economy and the risk of supply side inflation spilling over into a wider inflationary process. However, the policy rates were left unchanged as it was felt that the recovery was still to fully take hold and that pre-mature tightening might undermine the recovery process. Subsequent developments show that the recovery is increasingly taking hold. On the other hand, inflationary pressures have accentuated and have been spilling over to the wider inflationary process. The recent industrial production data suggest revival of private demand, which could potentially add to inflationary pressures.
The three-month moving average of seasonally adjusted IIP does indeed show a robust number of 20.9%. I am personally skeptical about what is going on there, given that the level of seasonally adjusted IIP capital goods jumped from 440.4 in November to 623.4 in December. This kind of jump has pretty much never been seen before. It shows up in statistical tests as an outlier. So it could be that something remarkable is going on, or it could be a mistake in measurement. Given the difficulties and non-transparency of IIP measurement, I would lean towards the latter.

Inflation forecasts

Headline WPI inflation on a year-on-year basis at 9.9 per cent in February 2010 has exceeded our baseline projection of 8.5 for end-March 2010 set out in the Third Quarter Review. Year-on-year WPI non-food manufacturing products (weight: 52.2 per cent) inflation, which was negative (-0.4 per cent) in November 2009, turned marginally positive (0.7 per cent) in December 2009 and rose sharply thereafter to 2.8 per cent in January 2010 and further to 4.3 per cent in February 2010. Year-on-year fuel price inflation also surged from (-)0.8 per cent in November 2009 to 5.9 per cent in December 2009, to 6.9 per cent in January 2010 and further to 10.2 per cent in February 2010. With rising demand side pressures, there is risk that WPI inflation may cross double digits in March 2010.
The RBI statement does well to discuss WPI non-food. (The most useful thing to look at is WPI minus food and minus fuel). However, the right measure of what is going on now is the point-on-point change in seasonally adjusted levels. The year-on-year change (used above) is the average of the changes of the last 12 months, which is not a good way to make policy today. The datedness of information is accentuated by the fact that data for February is being used to make a decision in end-March.

It makes more sense to use point-on-point seasonally adjusted data, and to avoid food and fuel. The picture we see is quite striking: while the year-on-year change of the WPI (overall) is 9.89%, the latest value for the three-month moving average of seasonally adjusted WPI (manufacturing) is just 4.69%. Further, this is overstated because it contains sugar and food processing, both of which are showing high inflation.

The most sensible measure to look at is seasonally adjusted core inflation (i.e. WPI ex food and fuel). The second best, which is available at our website, is seasonally adjusted WPI Manufacturing.

The inflation scare is considerably overstated owing to the disproportionate attention being paid to old information (i.e. the use of year-on-year changes in prices) and to food and fuel (as opposed to core inflation).


Inflation is very important. There are few things that matter more for business cycle stabilisation than achieving low and stable inflation.

But we need to measure inflation correctly, and have an analytical capability for forecasting inflation. And, we need a well developed bond market and banking system for RBI to have a significant influence upon inflation. Until financial reforms are undertaken, RBI's actions lack teeth.


  1. Hi Ajay,
    After the tightening of RBI, the interest rate hike is on the anvil. So the rupee appreciation is inevitable. How much rupee appreciation you see in the coming months, say in the second part of the financial year 2011. If you could put up an article regarding the rupee appreciation in the coming days, it would enlighten the currency novice like me.

    Thank you,
    Contra Costa, CA

  2. i am really agree with these point these point are essential before investing.


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