While it is generally accepted that CPI inflation has come down in India, there is still considerable debate as to the causes of this decline and whether this decline is sustainable. The answer to these two questions is extremely important for gauging the future course of monetary policy. Governor Raghuram Rajan approvingly cited a recent RBI study (“What is responsible for India’s sharp disinflation”, Sajjid Chinoy, Pankaj Kumar and Prachi Mishra, working paper, August 2015) on the two questions. This study, he stated, had three important conclusions: “First, that the good inflation news follows from a combination of good food management by the government, good luck because of external factors such as lower crude prices, and monetary policy, including the new framework. We believe this is a fair view of the disinflation so far, entirely uninfluenced by the fact that two of the three authors are from the RBI.” (‘Inflation fears still high, says Rajan’, Business Standard, August 25).
Chinoy in a Mint article (‘Making sense of Inflation in India’, August 24) discounted the efficacy of good food management by concluding that “the variation in MSPs [minimum support prices] is largely mimicking world food prices” and that “a secular decline of global food inflation over the last year has likely had an important impact on India’s food inflation”. So what brought inflation down, if not MSPs, according to Chinoy? Why, oil and international food inflation, of course.
As readers of this column know, I have talked (since July 2011) about the importance of government-administered MSPs for food as being almost the determinant of CPI inflation in India. No other variable (money supply growth, fiscal deficits, output gap, etc) has any explanatory power in explaining Indian inflation from the late 1970s to the present. However, there is an additional important determinant — the effect of international inflation as proxied by the median inflation rate in emerging economies. But this ceased to be relevant to the Sonia Gandhi-inspired MSP explosion during 2004-13, that is, international inflation effects were swamped (eliminated!) by the extraordinarily high MSPs engineered by Gandhi’s government (no doubt in the mistaken belief that such increases would yield a majority of seats in Parliament).
What effect did the oil price decline have on inflation, as suggested by both Rajan and Chinoy? Recent history provides for a “natural” experiment about policy choices and determinants. In June 2008, oil prices reached $134 per barrel and year-on-year CPI inflation was 8.3 per cent. A year later, in June 2009, oil collapsed to $70 and CPI inflation increased by 2.2 percentage points (ppt) to 10.5 per cent. Compare and contrast this with what happened in the recent one-year period, June 2014-15. Oil prices declined from $105 to $60. But, in contrast to 2008-09, CPI inflation fell by 1.4 ppt from 6.8 to 5.4 per cent (and by 3 ppt to 3.8 per cent in July). So if oil prices are responsible for the decline in inflation in India in 2014-15, why did inflation decline not happen in 2008-09? One major explanation: (lagged) MSP increased by 15.9 per cent in 2008 and 20.9 per cent in 2009; in contrast, (lagged) MSP increased by 5 per cent in 2013 and 1.8 per cent in 2014.
What about international food prices and CPI inflation? Ditto the same story as oil. In 2008-09, international food prices fell by 23 per cent, but domestic food price inflation increased from 10.5 to 12.2 per cent. In contrast, in 2014-15, international prices fell by 24 per cent, and food inflation declined from 7.3 to 5.7 per cent.
These data do not lend much support to Chinoy’s contention that the real influence on CPI inflation is international food inflation. When several explanatory variables are contenders for being a determinant, the standard procedure is to run a “horse race” between them. In such a race, (lagged) international food or cereal inflation lags far behind as a determinant — indeed, it is completely insignificant and, to add insult to injury, of very low magnitude. However, lagged MSP inflation remains a star determinant and with a healthy magnitude — each 1 per cent increase in lagged MSP leads to 0.4 per cent increase in CPI.
Of the three “determinants” mentioned by Rajan, one remains to be evaluated: The monetary policy framework as being (partly) responsible for the decline in inflation. The inflation targeting framework is not yet in place, though the tabling of the Urjit Patel report is coincidental to the beginning of the decline in inflation. It is hard to believe that this correlation is anything but that; in addition, the MSP increase of only 5 per cent in 2013 may have been an important contributor to the decline in inflation, which started in 2014.
So what has determined Indian inflation to date? Mostly MSPs. Going forward, it is likely that MSP inflation will cease to play an important role in Indian inflation. Why? Because the country has learnt from the inherent dangers of populist policies engineered by Gandhi and her UPA government. It will be a case of never-again. So what will determine domestic inflation? The RBI’s interest rate policy?
When was the last time the RBI’s rate policy determined inflation in India? This is not a rhetorical question; it deserves an answer. Growth, jobs, poverty reduction and human welfare are at stake, so a glib answer is not desirable. The simple fact is that the world has changed, and radically so, from when most of us studied monetary economics. Just look at what has happened in the rest of the world for the last 20 years and continuing. Most major economies have reduced policy rates to zero and inflation has declined. It is high time the monetarists woke up and smelt the cheap coffee or anything else they are fond of.
Deflation is likely to soon become a major concern in India. My preliminary estimates suggest that y-o-y GDP deflator inflation in India, for the April-June quarter, will be in negative territory. By the way, there is a flipside of negative or low deflator inflation to GDP growth as well — don’t be surprised if y-o-y growth is closer to 9 per cent than the 7 per cent widely being predicted.
Soon the search process for the monetary policy committee (MPC) will begin. I suggest that the RBI screen each contender for the MPC with this question: How do you explain the past determinants of inflation in India, and how do you explain the future trend?
The writer is contributing editor, ‘The Indian Express’, and senior India analyst, The Observatory Group, a New York-based policy advisory group.