T C A Srinivasa-Raghavan: How much does monetary policy matter?

OKONOMOS

Sector-specific factors matter far more because only about 15 per cent of individual sectoral price fluctuations are due to monetary policy.

In a few days from now, the RBI will have to decide whether it wants to raise price of money again or not. What factors should it base its decision on? Inflation, of course, is the ever-green reason. It is soldiering along nicely at around 5.6 per cent. Much depends on whether the RBI thinks it could accelerate in the coming weeks. It seems to think it will.

But do prices rise because of factors specific to the sector or because of monetary policy? If so, how long do such increases last? How do you evaluate the relative importance of supply side factors and of demand side factors? What is the causal chain between the two?

In a recent paper*, Jean Boivin, Marc Giannoni, and Ilian Mihov have examined US data on consumer and producer prices. Their objective is to see which bit of inflation is due to macroeconomic factors and which bit is due to industry or firm-specific factors.

Overall, they say, "We estimate the effects of US monetary policy on disaggregated prices," because only if you do this, can you get a better handle on the nature of inflation. Their results should, at the very least, spur the RBI into conducting a similar study for India.

First, it turns out that sector-specific factors matter far more than monetary policy. "Only about 15 per cent of individual sectoral price fluctuations, on average, are due to aggregate macroeconomic factors," the paper states. This, I might add, is very close to the Marxian view that "prices are determined in the commodity markets."

But, second, what if a sector witnesses persistent inflation? This sort of persistence, say the authors, is "driven by common or macroeconomic shocks, and not by sector-specific disturbances."

So, third, this suggests that sectoral prices respond differently to different stimuli. The results show that even when sector-specific shocks cause large fluctuations in industry prices, these fluctuations don't last for long. But "aggregate macroeconomic shocks instead tend to have more persistent and sluggish effects on a wide range of sectoral inflation rates."

Fourth, there is the usual lag, so that if you fiddle with the price of money, the effects become known only much later. There remains, however, the dreaded "price puzzle" wherein reductions in liquidity or higher interest rates "" or as is more usual, both "" lead to an increase, instead of a decline, in the price level. Happily, however, this was a phenomenon of the 1960s and 1970s and has more-or-less disappeared since the 1980s, at least in the West. We don't know if it has in India.

The trick is to tighten monetary policy in such a way that it offsets supply shocks. This means the central bank has a key objective "" achieving price stability. Perhaps there have also been fewer supply shocks.

Fifth, most relevantly in the current context, there are elasticities to be kept in view. It makes intuitive sense to say that the higher the price elasticity, the greater will be the sector's willingness to absorb the shock instead of passing it on. Thus, "categories in which prices fall the most following a monetary policy shock, tend to be those in which quantities consumed fall the least."

Market power also plays a role in determining how a firm responds to tighter money and "prices react more rapidly to monetary policy shocks in sectors with volatile idiosyncratic and persistent idiosyncratic shocks."

In the Indian context, in the event that the RBI does commission a study along these lines, it should also check on what actually constitutes a shock. That is, is homeopathy useful in monetary policy or not and whether homeopathy of one sort (25 basis point increase) is better than homeopathy of another sort (a small increase in CRR).

*Sticky Prices and Monetary Policy: Evidence from Disaggregated US Data NBER Working Paper number 12824, January 2007