Is India overheating?

Eight myths about inflation

Kalpana Kochhar & Charles Kramer

Is the current inflation spiral primarily on account of agricultural shortages? Will the RBI's policy of raising interest rates kill the current
expansion? The pickup in headline inflation from about 4 per cent to over 6 per cent during the last 12 months, and the Reserve Bank of India's moves to rein it in, have sparked a vigorous debate in India. In our view, inflation is a problem - and the RBI has been correct in taking steps to bring it under control. The debate has given rise to eight myths about inflation in India. It is useful to examine each of these myths so as to gain a clearer view of the issues - and the appropriate policy response. It's all about food prices. Inflation stripped of food and energy, or other volatile components, is still rising. For example, between March 2006 and March 2007, year-on-year wholesale price index inflation excluding food and energy rose from 2 per cent to 7.9 per cent. The pickup in inflation is all due to base effects from last year's low inflation . The notion is that depressed inflation in early 2006 exaggerates the rise in inflation during early 2007 on a year-on-year basis. But the three-month moving average of month-on-month, seasonally adjusted inflation has risen by about 3 percentage points over the past year - the same as year-on-year inflation. Inflation will fall back to a normal range on its own. Leading indicators of inflation point one way: continued price pressures. Excess capacity has shrunk to a 14year low, according to the NCAER. In addition, there are signs of overheating in real estate and labour markets, with surveys showing the salaries of skilled workers rising by around 15 per cent annually. Broad money growth has hardly slowed, still registering about 20 per cent year-on-year. With nominal GDP growing at about 14 per cent, this seems a classic case of too much money chasing too few goods - a recipe for inflation. Fresh capacity will come onstream soon and alleviate constraints (or, what we really need are reforms to encourage supply). Investment and reforms are welcome - not just to combat inflation, but to generate growth and employment that can alleviate poverty and raise living standards. However, they take too long to come onstream to dampen inflation now. Indeed, inflation has risen despite double-digit growth in private fixed capital formation over 2002/03-2005/06, accompanied by an 8.5 percentage point rise in the ratio of overall investment to GDP. Monetary tightening will kill the expansion . Keeping inflation under control, in fact, is key to sustaining the expansion. Waiting until inflation rises to higher levels will only make the job of stabilising prices harder. The international experience on this score is clear: When inflation expectations get entrenched at high levels, central banks have to tighten even more sharply to get inflation down. Administrative measures are as good as - or better than - monetary tightening for controlling inflation . Some administrative measures can work against inflation control in the long run by discouraging supply. Banning exports and futures trading for selected commodities, for example, raises the cost of doing business and creates uncertainty about the regulatory environment. This can only discourage production, worsening supply constraints. A stronger rupee does nothing to control inflation. A stronger rupee helps reduce inflation because it lowers the import prices of oil, other raw materials and capital goods and this, in turn, lowers the cost of production. It also reduces the prices of import-competing goods, like steel. A related myth is that a strong rupee will kill the economy by hurting exporters. A stronger rupee does reduce the rupee value of export earnings - but it also reduces the cost of imported inputs, and to the extent that it dampens inflation, it limits the need for interest-rate hikes. Moreover, exporters are in a robust position now: as an earlier article in this newspaper pointed out, among 808 companies surveyed, net profits rose 67 percent in the October-December quarter. Policy tightening will deny credit to small businesses and the common man, as well as hurt the poor . It is true that small businesses and the common man have only limited access to credit. This is a serious problem, but not one that can be solved through easy monetary

policy. The poor, meanwhile, not only have limited access to credit, but live on fixed incomes and have few or no assets to hedge against inflation - so that high inflation hurts them more than higher interest rates. Consistent with this idea, research by William Easterly and Stanley Fischer has shown that in a range of countries, higher inflation is associated with a lower share of national income accruing to the poor, a higher poverty rate, and a lower inflation-adjusted minimum wage. In light of these realities, the RBI is right to have taken steps to rein in inflation. Compared with many other emerging countries, India has an admirable record of price stability. Maintaining this track record will pay benefits in terms of sustained growth with macroeconomic stability, and it will protect the most vulnerable Indians from the ravages of inflation. Kalpana Kochhar is mission chief for India at the International Monetary Fund and Charles Kramer is a division chief responsible for the Indian economy.

How to tackle inflation

Ajay Shah

February 08, 2007

Is the government getting needlessly hysterical about inflation? Many people think it is okay to tolerate some inflation if, in return, it is possible
to sustain higher growth rates. Nothing matters as much for peace, prosperity and poverty alleviation as high GDP growth, so I would always advocate any policy which delivers higher sustained GDP growth. However, the link between inflation and growth is complex. High inflation does not give high growth. The growth miracles of Asia, where above 7% growth was sustained over a 25-year period, were not associated with high inflation. In fact, countries with high inflation have tended to have low growth. In the business cycle, an acceleration of inflation can support a temporary acceleration of growth. In India, expected inflation has gone up from roughly 3% in 2004 to roughly 7% today--a rise of 4 percentage points. Interest rates have risen by less than 4 percentage points. As a consequence, real interest rates have actually gone down. Borrowing has become cheaper; we have a credit boom; and this is giving heightened GDP growth. If inflation now stands still at 7%, this boost to GDP growth will fade away. Episodes where inflation went up are associated with a brief acceleration of GDP growth. A government can jolt an economy by raising the inflation rate. This heightened growth is not sustained. Conversely, achieving high sustained GDP growth is about fundamental issues of economic reform, and does not concomitantly require high inflation. One of the great strengths of India is that the political system just does not accept high inflation. This is one area where politicians have been ahead of the intellectuals. Inflation of 3% is politically acceptable, and inflation above 5% sets off alarm bells. The government that can jolt an economy by raising the inflation rate then has to go through the costly process of wringing out the inflation, to get back to 3%. Since there is no tradeoff between inflation and GDP growth, Parliament is right in demanding low inflation and high GDP growth. Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are very high and sometimes GDP growth rates drop sharply. This boom-and-bust cycle is unpleasant for every household. There is a powerful international consensus that stabilising inflation reduces this boom-and-bust cycle of GDP growth. The ideal combination, which has been achieved in all mature market economies, is one involving low inflation, which is also predictable and non-volatile. Low inflation volatility induces low volatility of GDP growth. Low and predictable inflation also reduces the number of mistakes made by entrepreneurs in formulating investment plans. What India does not have is an institutional capacity for delivering predictable, non-volatile inflation of 3%.

In socialist India, the way to deal with an outbreak of inflation was to do government interference in commodity markets. A few commodities that "cause" inflation are identified, and the government swings into action: banning exports, giving out import licences, banning futures trading, sending the police to unearth "hoarding", etc. This is deeply distortionary. Milk exports were banned, and milk prices fell. But why should milk farmers pay for a macroeconomic problem of inflation? The cost of bringing down inflation needs to be dispersed all across the economy. If milk prices had been allowed to rise, then more labour and capital would shift from unproductive cereals to high-value milk production. India has the potential to be the world's biggest exporter of milk. But this requires a sophisticated web of producers, supply chain, exporters, factories, etc. This sophisticated ecosystem will not flourish when the government meddles in the milk industry. A meddlesome government will go through the whiplash of doing an MSP one day because milk prices are low and banning exports another day because milk prices are high. There is something profoundly wrong about a government that interferes in what can be imported and what can be exported. If the export of ball bearings were sometimes banned by the government, you can be sure there would be fewer factories to build ball bearings. India is evolving from a socialist past into a mature market economy. How can predictable, non-volatile inflation of 3% be achieved? The recipe that has been developed worldwide is to devote the entire power of monetary policy to this one task. In India, the RBI has a complex mandate spanning over many contradictory roles. This has led to failures on inflation control. In a mature market economy, a modern central bank watches expected inflation with great interest. Active trading takes place on the spot and derivatives markets, for both ordinary bonds and inflation-indexed bonds. Using these prices, a modern central bank is able to infer expected inflation. When the short-term interest rate is raised or lowered, in order to respond to changes in expected inflation, there is a slow impact on the economy, possibly spread over two to three years. A modern central bank has the economic knowledge required to watch out for expected inflation deep in the future, and respond to it ahead of time, so as to deliver inflation that is on target. In India's case, the RBI Act of 1934 predates modern monetary economics. In other countries, fundamental reforms have been undertaken in order to refashion monetary institutions in the light of modern knowledge. As an example, in the late 1990s, when Tony Blair and Gordon Brown won the election, they refashioned the Bank of England as a focused central bank which has three core values:

Independence: the Bank of England sets the short rate without involvement from the Ministry of Finance. Transparency: the entire process through which interest rate setting is done is fully transparent so that the financial markets always know exactly what is being done and why. Accountability: the Bank of England is accountable for hitting an inflation target. All tasks other than the inflation target were removed from the Bank of England.

The bad drafting of the RBI Act of 1934 is the ultimate cause of the distress of milk producers today. These linkages are not immediately visible, but they are very real. It is because India does not have a proper institutional foundation for monetary policy that we are reduced to distortionary mechanisms for inflation control.

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How does one calculate inflation? 9 Aug 2004, 0455 hrs IST,TNN Print Save EMail Write to Editor Discuss New Bookmark/Share

What is a price index? If you need to know how much the price of a particular commodity has increased in, say, the last year it is a simple enough computation.

However, if you need to give a figure for the increase in prices over a range of commodities, things obviously get more complicated, since individual commodity price variations are likely to be quite different. You could choose to say the price rise ranges from, say, 4% to 26%, but that is clearly less meaningful than if you could put a single number to it and say prices have on the whole risen by 8.3%. The purpose of a price index is to let you do just that. It does that by assigning different weights to prices of various commodities, so that you can get a weighted average of the price increases. The weights are needed because you surely wouldn't want the price of a tube of shaving cream ticket to be equated in importance with the amount you spend on petrol over a month. Why do we need so many price indices? There are different levels at which prices can be measured. The price of your vegetables is different for the wholesaler who buys it from the farmer, the retailer who gets it from the wholesaler and for you. We need different indices, therefore, to measure what is happening to prices a each of these levels. In India we have the wholesale price index (WPI) to track wholesale prices, as its name suggests, and three different consume price indices to track prices facing different categories of consumers industrial workers, urban non-manual employees and agricultural workers. The different CPIs are needed because the prices facing different consumer groups are different. Thus, while urban house rents may be of great significant to the first two groups, they would be of no consequence to farm labour. Thus the composition of each CPI is different and should ideally reflected the actual consumption patterns of the relevant consumer groups. What is the inflation rate we keep reading about? What is generally reported is the annual point-to-point inflation rate, which measures the change in the level of a price index over a full year. The CPIs in India are computed on a monthly basis, while the WPI is computed every week. Unless otherwise indicated, the inflation rate being referred to is normally the one based on the WPI. The year in this case would be 52 weeks. Thus when the papers report that inflation for the week ended July 24, 2004 was 7.5%, what this means is that the WPI for that week was higher by 7.5% than the one for the week ended July 26, 2003. It is important to realise that the point-to-point inflation rate reflects only the difference in prices over two specific weeks. Hence, if the inflation rate moves up from one week to the next, it need not mean that prices have actually moved over that period. It may equally be because there was a fall in the corresponding period of the previous year. This also explains why economists prefer to deal with average annual inflation rates rather than with point-to-point rates. Since the former involve averages of the index over longer periods, temporary blips are evened out, giving a more realistic picture of the trend.

What is the composition of the WPI? The WPI has an All Commodities Index, which consists of four three major groups Primary Articles; Fuel, Power, Light & Lubricants; and Manufactured Products. These are again broken up into smaller sub-groups. For instance, the primary articles group would have food articles, non-food articles and minerals. Each of these sub-groups would have several individual commodities in them. All told, the current WPI tracks prices of 435 commodities, of which 98 are primary articles, 19 fall in the fuel, power, light & lubricants group and 318 are in the manufactured products group. The WPI has been periodically revised from the time it was first constructed in the 1930s and for obvious reasons the weights have moved progressively in favour of manufactured products. The current index, which uses 1993-94 as its base year, has weights of 22.025 for primary articles, 14.226 for fuel etc and 63.749 for manufactured products.