Ajay Shah: Combating inflation

Short-term real interest rates have to be at least 3 per cent in order to reduce inflation.

The graph shows weekly data on year-on-year inflation for the overall WPI and for WPI manufacturing. When WPI inflation accelerated sharply, the government unleashed a slew of policy initiatives inspired by 1970s economics. It attacked hoarders, speculators and profiteers. Futures trading was banned in some cases; exports were banned in others. As the graph shows, this litany of bad economics achieved absolutely nothing in terms of denting inflation.

For many months, the RBI staff delivered stirring speeches about inflation control. Under the shroud of non-transparency, what the RBI was doing was focusing on manipulating the currency market. While the RBI was claiming to be concerned about inflation, it was actually fuelling it.

The RBI does not release daily data about its currency trading. However, an examination of the rupee-dollar exchange rate shows that the old exchange rate regime broke on March 15. A rupee appreciation of roughly 10 per cent took place after that. This was a big change in policy. The government had changed gear, refocusing monetary policy away from the currency to domestic inflation.

Did it work? The inflation experience lines up rather well with the date on which the currency policy changed. As the graph shows, WPI inflation peaked at the date of regime change, and dropped dramatically after that. The WPI release of March 17 was the peak""with overall inflation of 6.56 per cent and manufacturing inflation of 6.75 per cent. The latest data, dated May 19, show an improvement of 1.5 percentage points for both, when compared with the peak.

This is an important victory over inflation. It helps to break the inflationary spiral, which was starting to set in, with a wage-price spiral where inflationary expectations fuel inflation.

Why did a change in the currency regime generate a 150 bps drop in WPI inflation in two months? The first thing going on is the footprint of import parity pricing in the economy. The domestic price of steel""even the steel produced by SAIL""is the world price of steel multiplied by the exchange rate. Firms in India are invoicing""every day""by taking world prices and multiplying by the prevailing exchange rate. Where there is import parity pricing, the impact of rupee appreciation on prices is immediate.

After this, there are downstream effects""where cheaper raw materials propagate into the prices not governed by import parity pricing""with a lag. A statistical analysis shows that the full effect of an impulse of rupee appreciation upon the overall WPI plays out in 4-8 weeks.

Another impact works through a shift in aggregate supply/demand conditions in the economy. INR appreciation reduces export demand, which helps reduce overall prices.

Another factor is monetary policy. As Vivek Moorthy has emphasised, the RBI's withdrawal from the currency market made possible a monetary policy which was not compromised. However, monetary tightening plays out over a much longer timescale.

The overall WPI has three components: manufacturing, primary goods and fuel. Fuel prices were not changed by the government. The drop in both WPI manufacturing and in the overall WPI, depicted in the graph, was possible because WPI primary also fell nicely.

This drop in WPI primary comes as a surprise. Traditionally, in India, it is felt that primary prices are primarily about politics and not economics. However, while government is important for the price of wheat or rice, it does not directly interfere in a large set of agricultural commodities of growing importance, such as vegetables, fruit, meat, and milk. These markets are part of the normal rules of a market economy: prices are formed by a very large number of buyers and a very large number of sellers. Prices of many agricultural commodities are influenced, if not determined, by import parity pricing. When interest rates go up, people have less money to spend, which leads to lower purchase of milk products and thus lower milk prices.

What does the future hold? My calculations suggest that the impact of rupee appreciation to Rs 40.5 upon inflation has largely played itself out. Further developments on inflation now depend on monetary policy.

While it seems that a good victory over inflation has been scored, there are three key hurdles to cross. First, the WPI is a poor measure of inflation. The best inflation measure in India is the CPI-IW. These data come out with a long lag. Policymakers need to keenly watch the CPI-IW and keep score by it.

While a gain of 1.5 percentage points is nice, what India needs to shoot for is an inflation target of 3 per cent. Sound macro policy involves inflation which is "low enough to not matter". Anything above 3 per cent injects inflation considerations into the everyday decisions of firms and households. Monetary policy needs to keep its eye on the ball and ensure that CPI-IW inflation gets back to 3 per cent.

The third hurdle is monetary policy. Given the non-transparency of the RBI, it is not possible to tell what monetary policy is doing. However, there is surely something amiss when interest rates on the call money market are at zero per cent. A negative real rate is surely not a monetary policy stance that is consistent with obtaining a deceleration of inflation. It could be that the RBI is back to its old game of manipulating the currency market. Policymakers need to ensure that the RBI does not take its eye off the inflation ball.

The UPA needs to get inflation back to 3 per cent by late 2008 in time for the next general elections. This requires a restrictive monetary policy""short-term real interest rates have to be at least 3 per cent in order to reduce inflation. Going beyond petty political gains, when monetary policy does not deliver the goods of low and stable inflation, it has serious consequences. Fluctuations of inflation hinder private firms' decision making. Inflation volatility brings out the worst in Indian economic policy making such as banning the export of milk or futures trading in wheat. It destabilises capital flows and the financial sector, increases GDP growth volatility, and reduces GDP growth. Reform of the institutional framework of monetary policy is required, to ensure that instability of inflation""from 3 per cent in 2004 to 7.5 per cent and then hopefully back to 3 per cent by 2008""does not recur.