Deepak Mohanty: Perspectives on inflation in India
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Bankers Club, Chennai, 28 September 2010.
* * *
The assistance provided by Dr O P Mall, Dr Abhiman Das and Shri Binod B Bhoi is acknowledged.
I thank the Bankers Club, Chennai and Shri T.M.Bhasin, Chairman & Managing Director,
Indian Bank for providing me this opportunity to speak before you. As you know, the Reserve
Bank released its first Mid-Quarter Review of Monetary Policy for 2010-11 on September 16,
2010 raising policy interest rates for the fifth time since March 2010. The Reserve Bank is
concerned over the unacceptably high inflation rate. In the meanwhile, the Government has
also released the new series on the Wholesale Price Index (WPI) changing the base year
from 1993-94 to 2004-05.
Against this background, I propose to speak on inflation. I will focus on three issues. First, I
will place before you some salient features of the new series of WPI. Second, I will give a
snapshot of our history of inflation from 1952-53. Third, I will give a brief analysis of the
determinants of inflation. I will conclude with some observations on the nature of monetary
policy response in the past and in the current phase of inflation.
I. New series on WPI inflation
As you know, the Reserve Bank looks at various indices and indicators of inflation. WPI
inflation is taken as the headline inflation in India. The Reserve Bank's policy articulation and
inflation projection are in terms of WPI. Hence the new series on WPI is of particular
importance.
Considering the data for the past five years, 2005-06 to 2009-10, it is seen that there is not
much difference in average inflation rate between the new series and the old series which is
about 5.5 per cent (Table 1).
This similarity, however, masks a number of significant changes in the new series. First, the
basic feature of any price index updation is to adequately capture the current structure of the
economy, consistent with the consumption pattern and the price trends at a disaggregate
level. In terms of change in the relative weight of major commodity groups, the share of
primary articles has gone down by 1.9 percentage points, which has been compensated by
increase in the share of fuel group by about 0.7 percentage point and manufactured products
by 1.2 percentage points. There has been a reduction in weightage of primary food articles
and manufactured food products by 2.6 percentage points in the new series to 24.3 per cent
from about 26.9 per cent in the old series. Second, notwithstanding a significant reduction in
weightage, the food inflation in the new series is higher than in the old series. This is
because of change in the consumption basket in favour of protein-rich items such as egg,
meat and fish where price rise has been high apart from milk and pulses. Third, the non-food
manufactured products inflation is lower in the new series than in the old series. This is
because of a substantial overhauling of the basket with the introduction of a number of new
items. For example, the new series has 417 new commodities of which 406 are new
manufactured products (Chart 1). Fourth, the new series has wider coverage. For example,
the number of price quotation has increased from 1918 in the old series to 5482 in the new
series. The new series, therefore, is better representative of overall commodity price inflation.
II. Long-term inflation trend
The WPI series is available from the year 1952-53 onwards though the base year has
undergone revisions from time to time. The monthly year-on-year inflation for the 56 years
from 1953-54 to 2009-10 is plotted in Chart 2. A visual impression of Chart 2 suggests the
following. First, inflation was quite volatile in the initial three decades of the 1950s, 1960s and
1970s. But the volatility has reduced in the subsequent decades even with occasional spikes
in inflation. Second, since the high inflationary phase of the mid-1990s, the inflation rate has
moderated. It has remarkable stability coinciding with great moderation globally except for
the recent two brief episodes of double digit inflation each persisting about 5 months in
June-October 2008 and then during March-June 2010.
Going by the current experience of 5-6 months of double digit inflation as high, one can trace
9 such episodes in the last 56 years. Out of these 9 episodes, double digit inflation lasting
beyond a year occurred on 5 occasions. The most prolonged one lasted for 30 months
during October 1972 to March 1975. The last such high inflation was in the mid-1990s which
lasted 15 months between March 1994 and May 1995. The Reserve Bank responded to the
phases of high inflation through available policy instruments (Table 2 and Chart 3).
BIS Review 127/2010
BIS Review 127/2010
Notwithstanding these episodes of double digit inflation, it is important to recognize that India
has been a moderate inflation country and the average inflation has come down over the last
15 years. For the 56 years period from 1953-54 to 2009-10, the monthly annual average
inflation is around 6.7 per cent. There has particularly been a perceptible drop in the average
WPI inflation to about 5.1 per cent in the last decade during 2001-02 to 2009-10.
III. Determinants of inflation
There are factors, both from the supply side and the demand side, which explain the
behavior of inflation. But a common thread runs through the periods of high inflation. These
typically include any one or combination of the following: (i) war, (ii) drought, and
(iii) commodity price shocks, particularly oil prices. Supply shocks accompanied by demand
pressures such as high fiscal deficit reflected in high money supply growth further
accentuated inflationary pressures.
In a long-term framework, the inflation rate can be hypothesized to evolve around a trend.
The underlying trend can be considered as the core which is largely influenced by demand
conditions. However, for developing countries like India, medium-term supply response
corresponding to the changes in demand conditions is important to the determination of the
trend. For example, in our case we have seen a sharp reduction in trend inflation during the
2000s on improved supply response following wide-ranging economic reforms and
liberalization initiated in the 1990s in the real and financial sectors. Emphasis on fiscal
consolidation, discontinuation of the practice of automatic monetization of fiscal deficit,
market determined exchange rate system and greater reliance on price signals vastly
improved the underlying macroeconomic framework. These had a positive impact on our
macroeconomic preferences, including a clear drop in the long-term inflation trend and a
decline in the volatility of inflation with a step-up in economic growth (Chart 4).
The fluctuations around the trend are determined more by the severity of supply shocks and
the nature of policy responses. One of the recurrent supply shocks influencing inflation
conditions in India emanates from the agricultural sector due to drought conditions (Chart 5).
Food inflation, which has always been a major source of fluctuation in the headline inflation,
has a significant negative correlation (-) 0.5 with 2-year average growth in agricultural GDP.
If the supply shock is prolonged and monetary policy remains accommodative for an
extended time period, supply induced inflation tends to get generalised. This is a lesson
learnt in macroeconomics following the oil price shock of the early 1970s which triggered a
world-wide inflation. Hence, policy authorities were wiser in handling subsequent supply
shocks by not extending policy accommodation beyond a point. Fiscal deficit was a major
factor in the determination of inflation in the 1980s. With fiscal consolidation after the
mid1990s, monetary growth became more commensurate with the overall economic growth
contributing to reduction in inflation (Chart 6).
Against this background, let me now turn to a simple but more formal assessment of the
determinants of long-term inflation which can be considered as output and money supply.
Since agricultural GDP is frequently interrupted by weather conditions, non-agricultural GDP
and money supply can be considered as the more relevant variables in the determination of
the inflation trend. Empirical exercise based on annual data for the 57 year period, 1952-53
to 2009-10, shows that there is a co-integrating long-term equilibrium relationship among
inflation, non-agricultural GDP and money supply.1
From this exercise, the following inference can be drawn. First, non-agricultural GDP has a
highly significant and negative relationship with inflation, which implies that an increase in
non-agricultural GDP representing improved supply condition will decrease inflation. Second,
money supply has a highly significant and positive relationship with inflation. One per cent
increase in money supply in absence of any increase in non-agricultural GDP could lead to
0.9 per cent increase in inflation. Third, alongside increase in money supply by one percent,
if non-agricultural GDP also increases by one per cent it will have a dampening effect on
inflation. But still inflation could go up by 0.15 per cent in the long-run. Fourth, deviation from
the long-run equilibrium is statistically significant and the adjustment towards the long-run
equilibrium is faster through changes in the non-agricultural GDP.2 Fifth, there is a two way
causal relationship between money supply and prices.3
Notwithstanding this relationship, inflation has strayed from its long-term path from time to
time. The upward spikes in inflation from its trend are explained by significant supply shocks.
Generally, high inflation periods were coincident with episodes of oil price surge and drought
conditions. This can be seen from the plot of residual from the long-term equation (Chart 7).
This pattern is more pronounced when plotted against the actual inflation rates (Chart 8).
IV. Conclusions
The above discussion leads to the following major conclusions. First, the new series of WPI
inflation marks a major change in terms of scope and coverage of commodities and is more
representative of the underlying economic structure. As per the new series, the
manufactured products inflation is lower than what was seen on the basis of the old series.
The food price inflation, on the other hand, is higher than what was seen on the basis of the
old series. The high level of food prices is indeed a matter of concern as the prices of
protein-based items, which have a higher share in the consumption basket, are showing
larger increases. Moreover, there is continuing shortage of food items such as pulses and
edible oils. If the supply response doesn't improve, there is a risk that food price inflation
could acquire a structural character.
Second, historical data show that India is a moderate inflation country. But there have been
phases of sharp spikes in inflation emanating from war, drought and commodity price
shocks. Supply shocks when accompanied by demand pressures further amplified
inflationary pressures. But the inflation rate has reverted to its trend following policy response
and improved supply conditions. In the periods of high inflation, monetary policy responded
with a combination of available policy instruments through changes in policy interest rates,
cash reserve ratio (CRR), statutory liquidity ratio (SLR), and in the earlier regime through
increased in administered interest rates and credit control.
Third, the volatility as well as incidence and duration of double digit inflation has reduced
over time. Inflation control since the mid-1990s has been particularly successful which can
be attributed to wide ranging reforms which have improved the macro-policy framework and
eased supply constraints.
Fourth, the long-run inflation trend is determined by non-agricultural GDP and money supply.
Increase in money supply unaccompanied by a commensurate increase in non-agricultural
GDP is potentially inflationary.
Finally, with the reduction in average inflation and inflation volatility, since the mid-1990s,
tolerance for high inflation has come down. The moderation of inflation trend has had several
beneficial effects in terms of lower nominal interest rate and high GDP growth rate. Given the
remarkable stability in the inflation rate since the mid-1990s, it is important to persevere with
appropriate policy responses so that the high inflation seen in the recent months does not get
entrenched. Even if the trigger for inflation is from supply side, its persistence necessitates
monetary policy responses to bring the inflation rate back to its trend and anchor inflationary
expectations.