Updated: October 7, 2014 8:03:53 am
Ill-thought-out assertions about the efficacy of monetary policy can unhinge private expectations of inflation.
The Indian Express recently published two articles by Surjit S. Bhalla on the subject of inflation in India (‘Where monetary policy is irrelevant’, September 13 and ‘RBI, we have a problem’, September 20). Bhalla’s central thesis is that inflation in India is primarily driven by changes in the minimum support prices (MSP) for agricultural goods. He then uses this “fact” to argue that, since monetary policy has no effect on inflation, the Reserve Bank of India (RBI) should lower interest rates to spur growth. However, both his conclusions are problematic.
Let us start with the relationship between the MSP and inflation. Given the large share of food in the consumer price index (CPI), no one can or should argue that increases in the MSP have no inflationary consequences. Rather, the key question to ask is what factors cause the MSP itself to move. While the government possibly takes into account a number of factors in determining the MSP, a key input is clearly inflation itself. Rising overall price levels, without corresponding increases in agricultural prices, implies a loss of real purchasing power for the farmer. Increases in the MSP provide the farmer with insulation against such a loss.
In as much as the MSP itself responds to current and past inflation, a part of the reported effect of the MSP on inflation is then just the effect of past inflation on current inflation, rather than any independent effect of changes in the MSP on inflation. The MSP may well have an independent effect on inflation, but to determine that one needs to break up MSP inflation into two parts: the part that is induced by current and past inflation and the part that is not. The key test then is to see which of these two components of the MSP has the bigger effect on inflation.
Using the CPI (industrial workers) and a weighted MSP index for the period of 1976-2014, I did precisely that exercise. The bottom-line of the results is that, using the part of the MSP due to past inflation to predict inflation does almost as good a job
as using the overall MSP. Moreover, when both components of MSP changes are used to predict inflation, the effect of inflation-induced MSP is three times as high as that of non-inflation MSP. The main implication of this is that the biggest predictor of inflation is past inflation. It is clear that past MSP changes due to inflation account for a much larger part of overall CPI inflation than does non-inflation MSP.
There is an even bigger kick to these results. If one predicts inflation using both components of the MSP, but using data only till 2008 or earlier (Bhalla uses data till 2004), the only significant predictor of inflation turns out to be inflation-induced MSP. Statistically, non-inflation MSP had no effect on inflation between 1976 and 2008. Put differently, the small effect of non-inflation MSP on inflation is driven entirely by the post-2008 data, which is a very short period of time relative to the overall period of 1976-2014. The upshot of this is twofold: one, fluctuations in CPI inflation in India between 1976 and 2014 are mostly due to fluctuations in past inflation rather than independent MSP changes; two, the little predictive power of non-inflation MSP during this period is entirely due to the short period of the post-2008 data. These facts hardly support Bhalla’s rather sweeping conclusion that inflation in India is entirely driven by changes in the MSP. Consequently, the second part of his analytic leap, that the RBI has no influence on inflation, does not follow either.
What explains inflation is a good question that this analysis does not answer. But to point at the MSP is to get the relationship a bit backwards. In any economy, different variables constantly interact with each other. Determining causal links between them is, therefore, fraught with complications. Finding a statistical link between two variables does not imply that the two variables are either causally or structurally linked. From a policy perspective, it is imperative to understand the structural link between variables.
Monetary policy is a serious and complex business. The ability of a central bank to influence inflation and output depends on a number of factors. The transmission from policy to the economy varies from country to country, fluctuates from time period to time period, is sensitive to the monetary regime and depends crucially on the inflation expectations of the private sector.
Intemperate and ill-thought-out assertions about the efficacy of monetary policy can unhinge private expectations of inflation. The RBI has been introducing a new monetary regime over the past year. The changes need time to work. It may be worth letting the experts do their job, rather than complicating matters by creating unnecessary confusion.
The writer is professor of economics, Royal Bank research professor and Johal Chair, University of British Columbia, Canada
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