We are all inflation targeters now, at least since the RBI published the Urjit Patel report on strengthening the monetary policy framework in India. Inflation, at 10 per cent-plus annually for the last six years, is something that definitely needs fixing. But is inflation targeting (IT) the right formula?
In order to understand that important question, one needs to know the determinants of inflation. The US gave up on the notion that the growth of money supply determines inflation sometime in late-1983, when it stopped reporting the eagerly watched money supply numbers on Thursday afternoons.
At that time, US CPI inflation had already come down sharply from its double-digit peak of 13.5 per cent in 1980 to around 3 per cent. After the peak of 5.4 per cent experienced during the Kuwait crisis (oil price) years of 1990-91, US CPI inflation has averaged 2.4 per cent, with a peak of 3.8 per cent in the commodity peak year of 2008 and -0.3 per cent in the commodity trough year of 2009.
Now the US does not have inflation-targeting as a policy, and may have had a loose de facto targeting policy in the last decade. But it would be erroneous to conclude that the US experience supports the targeting idea, just as it would be equally erroneous to conclude that
all the Q (quantitative easing) liquidities have an impact on US inflation. Whether the Qs have an effect on asset prices remains an open question.
Do other country experiences support the notion that IT has been effective? The Patel report documents that 14 countries adopted IT between 1990 and 2000.
The example of inflation in Chile declining from 24 per cent in 1990 to 4.4 per cent in 2007 and inflation in the Czech Republic declining from 10.7 per cent 1998 to 2.9 per cent in 2007 is cited by the report as success stories. India, of course, did not have inflation-targeting but nevertheless CPI inflation did decline from a 11.2 per cent rate in 1990 to 4.4 per cent in 2005 and 6.2 per cent in 2007. The correlation of India’s non-targeted inflation rate with the targeted Chilean and Czech inflation rates is a high 0.73 and 0.66 respectively!
The fact remains that the last six years have witnessed a super, record high 10 per cent-plus CPI inflation rate and the RBI is rightly concerned about bringing it down by whatever means, even a targeting scheme with a dubious record. There are other suggestions, besides targeting, for bringing down inflation. For example, the IMF argues for a raising of repo rates until the cooling is in place.
They further argue, as many others in India, that if only the RBI had been vigilant and raised rates earlier, inflation would not have stayed persistently above 10 per cent levels.
The evidence suggests that the IMF (and their followers) have not quite understood the dynamics of inflation in India. Just look at the record — on every occasion the RBI raised rates in the last five years, the inflation rate went up! So empirical IMF logic would suggest that the best way for inflation to be brought down in India is not by targeting, not by raising rates, but by lowering rates. Sounds crazy — but hold that thought until we briefly review the inflation experience in India, its possible determinants, what the inflation situation is today, and likely to be in future.
Prior to 1972, Indian inflation was determined primarily by what happened in agriculture. Somewhat surprisingly, the average CPI inflation between 1960-1972 was as little as 4 per cent. The end-point 1972 is deliberately chosen because of the quadrupling of the price of oil in October 1973. Between 1973 and 1996, inflation averaged 9.1 per cent and then entered a stable zone of 5.4 per cent for the next eight years (1997-2004). The importance of agriculture declined in this period to less than 25 per cent of GDP.
But then a curious thing happened — Indian inflation became dependent on agriculture, despite significant improvement in yields, and production, and food stocks.
The period post-2004 is of course coincident with the UPA’s persistent efforts at political engineering, an engineering dedicated to win the rural vote via higher administered “support” prices for agricultural crops. These are not support prices, but maximum prices available to the farmers with the highest surplus — that is, the rich farmers.
Landless labourers lost out in this pro-rich populist UPA game. The result — overall inflation very high, cost of capital very high, and overall disgust with the ruling dispensation very high.
But there is a silver lining, too late for the Congress, but not too late for the economy which, unlike political parties, will be there for ever. Sometime in 2013, the anti-Sonia populism technocrats prevailed, no doubt helped by the in-your-face defeats of the Congress in assembly elections.
After rising by an average 13.5 per cent in the previous six years (2007-12), agricultural procurement prices (APP) rose by only 6 per cent in calendar year 2013. In 2012, the index rose at a 16 per cent rate; historical data suggests that this 10 percentage point decline in APP should lead to an average CPI inflation rate of 7.5 per cent in 2014.
The RBI’s target CPI inflation rate for December 2014 is 8 per cent and 6 per cent for December 2015. For three months, ending in February 2014, the annualised rates of CPI and WPI inflation are 1.1 and -3.0 per cent respectively. This three-month CPI rate is the lowest level since -0.3 per cent recorded in August 2003.
As the graph suggests, both CPI and WPI may be reflecting the beginning of a structural change in Indian inflation. To be above the RBI target of 8 per cent in December 2014, CPI inflation would have to average above 10 per cent for the rest of the calendar year. Of course, anything can happen, but the likelihood of the RBI 2014 target not being met is close to zero, and of CPI inflation reaching the December 2015 target of 6 per cent 12 months earlier is, in my humble opinion (or as Kejriwal would say, meri kya aukat hai), very high. Interest rate cut, anyone?
The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company