Lax macro-economic policy rather than food and energy shocks have stoked generalised inflationary expectations
Consumer price inflation has been virtually in double digits for three years and the wholesale price index (WPI) has accelerated and stayed stubbornly high. Compared to its own recent history, India’s inflation became unhinged, thereby reversing creditable performance, from as far back as 2006. In the last two years, among its major comparators India has the highest rate of consumer inflation; it is also volatile in relation to its peers in Asia. In the sphere of inflation, India is almost “decoupled” from its peers!
Disquieting and, frankly, obvious questions need to be raised on public policy grounds. Six per cent annual inflation has been described until recently as “comfortable” and “quite acceptable”. Is the suspension of long-standing conservative inflation targets temporary, or is this the new “normal”? Authorities want to take credit for India’s growth performance but stay blameless on the price front, a case of heads I win, tails you lose!
In the context of the public discourse on inflation, it is often the case that a few critical sectors are singled out as drivers of overall inflation. Typically, these factors are claimed by policy-makers to be outside their purview, thus, absolving themselves – at least partially – from the responsibility of inflation control.
It could be that Indian economic managers have not been remiss in “wait and watch” based on diagnosing the recent bout of inflation as narrowly based, that is, catalysed by specific sectoral causes that will reverse themselves and, ipso facto, headline inflation will decline without recourse to timely activist policy. Was the expectation that inflation in specific sectors will not transmit or diffuse through into other sectors either via a cost-push spiral or generalised inflationary expectations? It was hoped that (supposedly) narrow drivers of the extant spell of inflation were unlikely to continue, which does not appear to be based on any known analysis.
Alternatively, it may be argued that policy-makers deliberately chose to “fall behind the curve” in formulating, communicating and implementing requisite decisions. Were errors of judgment made in accommodating (individual) price level shocks emanating from the supply side?
In a recent Brookings Institution paper, “Dynamics of Inflation ‘herding’: Decoding India’s inflationary process”, we put forward a multidimensional empirical framework to analyse the time series and cross-sectional dynamics of inflation in India using a large panel of disaggregated sector prices for the time period 1994-95 to 2010-11. We rigorously explore issues that have been, at best, loosely posed in policy debates such as diffusion, or co-movement of inflation across sectors, role of economy-wide common factors relative to idiosyncratic drivers in explaining variation, degree of persistence, and importance of food and energy price changes to the overall inflation process. An analysis of cross-sectional distribution functions of inflation over the last 17 years show that the current episode, unlike previous periods of high inflation, stands out because it is characterised by both a high cross-sectional skew and high aggregate inflation, indicating that price changes across commodity groups have been upwardly “herding” in the sense that progressively more sectors are contributing to the overall price increase. We also find that, contrary to the general belief, a significant part of core sector (that is, non-food and non-energy) inflation since 2004-05 is driven by increasingly persistent aggregate or common factors. It would seem that the lax macro-economic policy environment, more than food and energy shocks, seems to have stoked generalised inflationary expectations, thereby making the overall inflation process highly inertial. Therefore, as against the hope of policy-makers, overall inflation may not moderate even if food and energy price shocks subside. The more broadbased inflation is, the less amenable it is to amelioration with minimal output losses. It may have dawned somewhat late on the Reserve Bank of India that the underlying drivers were getting stubborn, forcing it to undertake robust hikes in policy interest rates of late, that would not have been necessary if early action had been taken.
To corroborate the point about the possible delay in implementing inflation control policies, we compute a new indicator of underlying inflationary pressure, viz. Pure Inflation Gauges (PIGs), in the Indian context. PIGs measure the inflationary pressure on all commodity sectors that is primarily due to economy-wide or aggregate factors as against sector-specific supply and demand imbalances. While aggregate WPI inflation by the end of 2008-09 had declined to about one per cent (from about eight per cent in 2007-08), PIGs were running at around three per cent; in contrast to the headline inflation, the most recent trough in PIGs was 2005-06 and not 2008-09. The decline in (and the level of) headline inflation in 2008-09 may have conveyed to the authorities that they had less need for (or more time for) tightening than was the case looking at inflation measures corrected for sectoral and idiosyncratic shocks. The steep decrease in aggregate inflation (with even talk of generalised deflation) may have informed the hasten-slowly (“lack of alacrity”) strategy of RBI; the resultant extended period of softer-than-warranted policy allowed generalised inflationary expectations to take hold, which has been captured by the evidence on “herding”. The ensuing most recent period of high inflation followed, with headline inflation staying stubbornly in the seven-11 per cent range, and even PIGs in excess of five per cent, for most of the last two years. If PIGs, in conjunction with our other findings, for example, on persistence had been used as a measure of underlying (pure) inflationary pressures, the monetary authorities may not have been sanguine regarding the timeliness of initiating anti-inflationary policies, that is, they would not have underestimated the underlying inflation in 2008-09.
In conclusion, the current period of high inflation is more cross-sectionally diffused, and driven by increasingly persistent economy-wide factors in non-food and non-energy sectors compared to that in the 1990s; this is likely to make it more difficult for anti-inflationary policy to gain traction this time round compared to the past.
These views are personal.
Emails: gangadarbha@yahoo.com; urjitpatel@hotmail.com
