India’s Inflation Crisis: What This Means for Monetary Policy

by Ajay Shah

Click on graph for larger image.

The graph above shows headline inflation in India, i.e. year-on-year CPI-IW inflation. The informal target zone for policy makers in India is to have year-on-year CPI-IW inflation between four and five per cent. This is shown on the graph as blue dashed lines.

From February 2006 onwards, inflation breached the upper bound of five per cent. It has never come back below five per cent. The red line shows the overall average inflation from 1999 to today: it is well beyond the upper bound of five per cent. If our informal goal was to get inflation between four and five per cent, we have failed to do this as measured by average inflation from 1999 onwards (averaging across both good periods and bad).

Our loss of price stability is a major weakness of macroeconomic policy. It has far reaching consequences and hampers the extent to which the economy is able to get back onto a stable growth trajectory.

That’s the big picture. Now let’s look at current inflationary pressures. For this, we must look at the month-on-month annualised changes in the seasonally adjusted CPI-IW. This data shows difficulties in 2012:

Jan      8.68

Feb     13.22

Mar    17.88

Apr     20.22

May    8.62

Jun     7.78

Jul       7.18

Aug    13.06

The target — year on year CPI-IW inflation — is the moving average of the latest 12 values of month-on-month inflation. If we hope to get y-o-y CPI-IW inflation below 5 per cent sometime in the coming six months, then the latest six months should contain good news. But there isn’t a single month of data in 2012 where the month-on-month CPI-IW inflation was within the target zone of four to five per cent. It is, hence, likely that we’re atleast a year away (if not more) for y-o-y CPI-IW inflation to drop below 5 per cent.

Inflationary expectations are in excess of 10 per cent; the policy rate expressed in real terms is negative. Under these conditions, I fail to see how many people are thinking it’s time for RBI to cut rates.

As India becomes a middle income economy, and experiences business cycle fluctuations, we’re going to require a quantum leap in the institutional and human foundations of macroeconomic stabilisation. One key component of this is an institutional commitment at RBI to deliver low and stable inflation.

Some argue that private sector confidence, and stock prices, will be boosted by a rate cut. Will it? Will the private sector be impressed by a display of low institutional capacity? Will lower rates foster investment? I’m curious to see how this will work out.

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About the Author

Ajay Shah studied at IIT, Bombay and USC, Los Angeles. He has held positions at the Centre for Monitoring Indian Economy, Indira Gandhi Institute for Development Research and the Ministry of Finance, and now works at NIPFP where he co-leads the NIPFP-DEA Research Program. His research interests   include policy issues on Indian economic growth, open economy macroeconomics, public finance, financial economics and pensions.