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Saturday, October 27, 2012

India's inflation crisis, and what this means for monetary policy

The graph above shows headline inflation in India, i.e. year-on-year CPI-IW inflation. The informal target zone for policy makers in India is to have year-on-year CPI-IW inflation between four and five per cent. This is shown on the graph as blue dashed lines.

From February 2006 onwards, inflation breached the upper bound of five per cent. It has never come back below five per cent. The red line shows the overall average inflation from 1999 to today: it is well beyond the upper bound of five per cent. If our informal goal was to get inflation between four and five per cent, we have failed to do this as measured by average inflation from 1999 onwards (averaging across both good periods and bad).

Our loss of price stability is a major weakness of macroeconomic policy. It has far reaching consequences and hampers the extent to which the economy is able to get back onto a stable growth trajectory.

That's the big picture. Now let's look at current inflationary pressures. For this, we must look at the month-on-month annualised changes in the seasonally adjusted CPI-IW. This data shows difficulties in 2012:


The target -- year on year CPI-IW inflation -- is the moving average of the latest 12 values of month-on-month inflation. If we hope to get y-o-y CPI-IW inflation below 5 per cent sometime in the coming six months, then the latest six months should contain good news. But there isn't a single month of data in 2012 where the month-on-month CPI-IW inflation was within the target zone of four to five per cent. It is, hence, likely that we're atleast a year away (if not more) for y-o-y CPI-IW inflation to drop below 5 per cent.

Inflationary expectations are in excess of 10 per cent; the policy rate expressed in real terms is negative. Under these conditions, I fail to see how many people are thinking it's time for RBI to cut rates.

As India becomes a middle income economy, and experiences business cycle fluctuations, we're going to require a quantum leap in the institutional and human foundations of macroeconomic stabilisation. One key component of this is an institutional commitment at RBI to deliver low and stable inflation.

Some argue that private sector confidence, and stock prices, will be boosted by a rate cut. Will it? Will the private sector be impressed by a display of low institutional capacity? Will lower rates foster investment? I'm curious to see how this will work out.


  1. Inflation in India is supply side induced and therefore, actions are required on that front – including measures to address the agriculture side...RBIs Oct'12 25 bps CRR reduction signals softening stance on tight monetary..

  2. RBI's really not doing this well. Since Dec, I have been wondering why RBI doesn't use more hawkish language (while taking exactly the same actions). RBI's main function today is to manage inflation expectations. It has failed to convince the market that it is concerned about inflation enough. Every action is seen as the last in the series, and everyone starts expecting a rate cut the next time around. How in the world are inflation expectations going to come down with this kind of messaging? Back in Dec, they could have made it clear to the markets that they were serious about inflation. Maybe, now with some conflict between PC and RBI, inflation expectations might temper down. This could have been done last year. If I remember right, then as now, RBI was saying that inflation will come down in a quarter. This sort of messaging is counter-productive.

  3. That inflation chart is very interesting and I keep thinking about it from various different angles. The inflation chart seems like a 2-3 year lagged version of the stock boom, asset inflation, commodities boom (especially if you consider the ramp from 2004 to 2007). I wonder if the high inflation from 2008 to 2010 was the price to be paid for the asset inflation and runaway growth from 2004 to 2007? Was it something to be addressed in 2005-2007 and were we behind the curve already in 2008? Are there any well-known long lag relationships between asset inflation and inflation, between money/credit growth and inflation? Any comments on this would be appreciated.


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