It is incorrect to argue that there is a weak relationship between money supply and inflation or that the RBI's policies have been backward-looking and reactive.
In a series of articles in Business Standard, Surjit S Bhalla has raised several issues pertaining to inflation management of the Reserve Bank of India. Apart from other issues, he completely rejects the association between money supply growth and inflation (‘Show me the evidence’, September 20). According to him, the pattern of money supply growth mattered for inflation in India just for seven years (1973-79) and no relationship was observed in the rest of the entire period during 1950-2008. An attempt has been made to re-examine this empirical relationship.
In any discussion of money supply and prices, the growth of the real economy needs due consideration. When economic growth accelerates to a higher trajectory, with commensurate rising money demand, a particular inflation target can accommodate higher money supply. Similarly, as economic growth slows down, the same money supply growth builds up inflationary pressure due to concomitant lower money demand. Thus, the fundamental issue is excess money supply over money demanded in alignment with economic activity is inflationary. In this context, we have tentatively estimated excess M3 growth over the demand assuming long-run income elasticity of 1.5. To make it simple, it is assumed that when the GDP growth goes up by 1 per cent, money demand increases by 1.5 per cent. [Various empirical studies have estimated this elasticity for India in the range around 1.75 during the earlier periods (prior to the 1990s) to around 1.5 including the recent period.] Thus, for a GDP growth rate of say 10 per cent, the money demand growth is estimated to be 15 per cent. Deducting this from the actual growth of M3, we got the excess money supply growth. Its co-movement with WPI inflation is plotted in Graph 2.
The above tentative analysis is also supported by formal econometric analysis (details can be obtained from the author). The Granger causality tests established feedback relationship between M3 and WPI i.e., M3 causes WPI and WPI causes M3 as well. Taking into account the dynamic interrelationship (considering lagged effects on each other) amongst GDP, M3 and WPI, an empirical analysis was carried out in a vector auto-regression (VAR) framework.
Bhalla has not given details of the methodology he has used to support his inferences. Without ignoring the role of supply shocks, our graphical analysis as also formal econometric exercise do not provide any evidence to compel us to ignore the role of money supply growth for explaining inflation in India. Nevertheless, similar to a high fiscal burden impeding monetary targeting prior to the mid-1990s, unprecedented international capital flows in the recent past posed considerable challenge for monetary management. Aware of the limitations of monetary targeting with the development of a broad-based financial market and financial innovations, the RBI has started de-emphasising this approach since the late 1990s.
Excessive reliance on M3: Other issues raised by Bhalla include what he calls the excessive reliance on M3. Contrary to the perception of sole reliance on M3 for monetary policy, RBI’s Statement on Monetary and Credit Policy for 1999-2000 had observed that, “the objective is to widen the range of variables that could be taken into account for monetary policy purposes rather than rely solely on a single instrument variable, such as, growth in broad money (M3). The experience of 1998-99 shows that money supply movements alone could not have provided adequate guidance for monetary policy initiatives during the year.” The RBI has been aware of the limitations of the exclusive use of M3 growth for monetary policy and since a decade before today has already started using a host of indicators along with M3 growth for drawing policy perspectives in a ‘multiple indicator approach’.
Backward-Looking and Reactive Policy: In the framework of ‘monetary targeting with feedback’ (during mid-1980s to 1997-98), the RBI’s policy decisions were based on the current macroeconomic developments and projections for the future, in which, assessment of the likely GDP growth and inflation determines appropriate M3 growth targets. For example, if the likely GDP growth is say 10 per cent, and assuming the income elasticity of money demand to be 1.5, the likely growth rate of money demand is estimated to be 15 per cent. Adding, tolerable inflation of say 5 per cent to it; the M3 target is arrived at to be 20 per cent. Can such an approach be called backward-looking?
WPI versus others: In terms of coverage, GDP deflator includes services which are largely excluded from WPI. But, GDP series being available at annual and quarterly basis in India, GDP deflators can only be obtained at a quarterly frequency at best. Moreover, data on quarterly GDP are published with a lag of 2-months. WPI data, on the other hand, is available with weekly frequency with a lag of two weeks. Using WPI inflation scores better in terms of forward-looking policy (what Bhalla advocates!) with revisions/updating the future projections from latest information. Despite advantages/disadvantages, similar movements of inflation do not lead to any strong urge to switch to GDP deflator in the face of time lag and frequency of information. WPI is also considered superior to CPI as a proxy for economy level inflation with advantages of better coverage, information lag, data frequency and base-year updating of the index. Nevertheless, the RBI has also been using information on CPI inflation for drawing policy perspectives.
The author is with the RBI. The views expressed are strictly personal and do not necessarily reflect those of his employer.