Financial Express, February 14, 2013

India’s inflation puzzle

India has been struggling with high inflation for over two years. The Reserve Bank of India (RBI) gradually raised its policy interest rate and has held it relatively firm, with only two small cuts coming recently. Meanwhile, economic growth has slowed dramatically. It has been asserted that RBI’s policy has contributed significantly to the growth slowdown. It has also been argued that monetary policy is ineffective in India, given structural rigidities and incomplete markets in the country’s economy. Fiscal policy and commodity prices have also been under the spotlight. What do we really know? 

A couple of weeks ago, Deepak Mohanty, an executive director of RBI, gave a speech in which he tackled India’s inflation puzzle. I will outline what he said, and then assess the arguments. Mr Mohanty first pointed out that India’s recent inflation surge and its persistence did not line up well with either its own history or what has been happening contemporaneously in the rest of the world. World inflation rose somewhat with the recovery from the Great Recession, but then moderated, while India’s inflation climbed to double digits. In India, moreover, a sharp growth slowdown seemed to do nothing to bring inflation down.

Mr Mohanty traces the start of India’s inflation spike to rises in the global prices of food, crude oil and other commodities. He refers to an unidentified analysis that pass-through of global price shocks to domestic prices increased in this recent period, and notes that corporate finance data are consistent with this increased pass-through. The depreciation of the rupee made the pass-through of external inflation that much worse. Mr Mohanty goes on to note the substantial increase in demand for higher-protein foods. He further documents the rise in real wages in rural India. He highlights the fiscal stimulus that coincided with the recession, and asserts that “higher fiscal expansion also impedes efficacy of monetary policy transmission.” Finally, Mr Mohanty emphasises that long-term inflation expectations rose in this period.

In examining the conduct of monetary policy as inflation spiked, Mr Mohanty emphasises that rises in interest rates trailed inflation, so that, starting from historically low interest rates, the real policy rate remained negative: “Thus, monetary policy was still accommodative though the extent of accommodation was gradually closing.” While all the other points made by Mr Mohanty have been widely recognised and detailed, it seems to me that this feature of recent monetary policy conduct has not received enough attention. Another important point that he highlights is that RBI’s estimate of India’s potential output growth rate has been reduced from 8.5% to 7%.

The story above is plausible, and draws on many analysts’ judgements. I have not been able to identify a publicly available structural model of the Indian economy that would allow one to say that the explanations above are the right ones, or to quantify their different contributions to India’s recent inflation experience. Formal, comprehensive empirical modelling is always a nice check on judgements that are necessarily fragmented and somewhat subjective. In the absence of a model, let me offer some additional thoughts, which may undercut the notion that India’s recent inflation experience should have been puzzling.

First, the monetary policy tightening was actually slow and even hesitant. There may have been good political and economic reasons for this, including fears about derailing an uncertain recovery, but RBI was neither choking off inflation nor growth in an assertive manner. Furthermore, RBI was not doing a good job of managing inflation expectations—interest rate hikes sometimes came with statements doubting if they would be effective. Sharper, faster interest rate hikes and confident statements would have worked. There is no puzzle in the experience.

Second, focusing on rising individual prices or on accommodative fiscal policy are both misleading. Yes, there can be short-term cost-push effects, and government deficits add to aggregate demand. But economic theory tells us that inflation is fundamentally a monetary phenomenon, having to do with the aggregate price level. The so-called fiscal theory of the price level, according to the best theoretical economic research that I have found, can tell us something about transmission channels, but not about long-run inflation.

Third, the growth slowdown has more to do with domestic political events that started to destroy India’s growth potential, more than RBI has estimated. The level of uncertainty for the private sector jumped. It is also true, I think, that government deficits have crowded out private investment directly. So fiscal policy has hurt potential growth. Global uncertainties and anaemic recoveries, especially in Europe, but also in the United States, have also worked to reduce potential output growth in India.

In sum, monetary policy was too timid, and failed to use the power of the word to complement actions; domestic economic management was dysfunctional in ways that reduced potential growth, while failing to account for structural changes in the economy; and global economic conditions exacerbated domestic policy shortcomings. This is a story with clear lessons and no puzzle.