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Business News/ Opinion / The Hindu rate of inflation
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The Hindu rate of inflation

Cooling persistent inflation requires a coherent fiscal and monetary policy mix. India needs that mix now

Photo: Mint Premium
Photo: Mint

Much like the era before 1980 when a culture of contentment with low growth prevailed—professor Raj Krishna famously called it “the Hindu rate of growth"—there seems to be a similar attitude in policy circles towards the current level of inflation. This makes one wonder if India has entered the phase of “Hindu rate of inflation".

The interpretation of the “Hindu rate of growth" being related to Hindu culture was criticized later by noting that the sluggish growth in question was experienced mostly under secular governments. Having said that, it will be grossly unwise for the present government to not think it self-destructive to be associated with the “Hindu rate of inflation". The increasing reaction to inflationary supply shocks, combined with unanchored inflationary expectations within the manufacturing sector are factors that both the central bank and the government must pay close attention to as soon as possible.

While Indians at large see plenty of attention being given to food inflation and supply shocks, the persistence of manufactured products inflation and impact of economic shocks on manufactured products inflation could also be making it harder for the central bank to get a hold on core inflation. Lack of a consistent macro and fiscal policy framework to deal with current levels of inflation is the main reason for a self-fulfilling expectations-bubble formation and consequent persistence of inflation in India.

Inflation persistence, in simple terms, means the continuation of inflation at around the same level despite the initiation of many policy measures to contain it. It is measured by the amount of change in inflation with respect to a policy shock or a supply shock. Inflation persistence can be attributed to various rigidities in the system including price and wage stickiness. Inflation expectations, which are driven by macro-economic fundamentals and an economy’s policy framework, play an important role in generating inflation persistence. If individuals expect that macroeconomic fundamentals are weak and the policy framework is inconsistent in dealing with inflation, they will take decisions that only fuels further inflation. For example, employees demand wage indexation and producers pass-through all of the cost shocks to consumers. In that sense, persisting inflation is an indication of a deeper malaise in economic policymaking.

It is also useful to distinguish between high levels of persistence and high inflation. A high level of aggregate inflation could be caused either by temporary shocks to few commodity groups, say shocks to food articles or energy prices; or it could be due to relatively permanent adjustments to prices across commodity groups. While both types of inflation are bad for society, the former is easily amenable to policy control and the latter, being more persistent, is harder to bring down. India experienced high levels of inflation in 1990s but it was not persistent and strong monetary policy action brought it down, albeit with some output losses. The current level of continued inflation points to a situation that we have not experienced before: inflation is not only high but highly persistent. A 2012 paper Dynamics of Inflation “Herding": Decoding India’s Inflationary Process (Gangadhar Darbha and Urjit R. Patel, Global Working Paper number 44, Brookings Institution) showed that during last five years there appears to be a herd-like behaviour among price revisions of various commodity groups, making the control of aggregate inflation much more difficult.

A much highlighted fact about current levels of inflation is that it is driven by a continuum of food and energy shocks and hence there is little scope for monetary policy to control it. But a less recognized fact is that the response of core-inflation (and hence the aggregate inflation) to food and energy shocks have also been increasing over last few years. For example, it has been found that the response of core inflation to a one per cent shock to food and energy prices during last five years is about three times larger than it was during mid 1990s. This clearly points to the fact that the Indian economy has become more inflation prone. Individuals seem to believe that current high levels of inflation are here to stay.

A case in contrast in this context is the US. It is now a well-documented fact that US inflation and economic growth have become relatively less sensitive to oil and energy price shocks over last three decades or so. This significant shift in the response of inflation to supply shocks from the past was attributed to the anti-inflationary policy framework initiated during the Paul Volcker years by the Federal Reserve. Such a transparent and credible policy stance had a moderating impact on inflationary expectations and their subsequent anchoring. In India, in contrast, lack of a consistent macroeconomic policy framework and a coordinated action plan between monetary and fiscal authorities has fuelled inflationary expectations and increased inflation persistence. Against this background, the Urjit Patel committee’s recommendation for creation of an inflation targeting monetary policy framework can be interpreted as an effort to bring in transparency in the conduct of monetary policy and anchor inflationary expectations. The Union government, instead of being apprehensive, should come out with a complementary fiscal policy framework that enhances the effectiveness and credibility of monetary policy. It must be understood that a mutually reinforcing monetary and fiscal policy framework is essential for the control of inflation.

Gangadhar Darbha and Surekha Nagabhushan are, respectively,with an investment bank in Mumbai and a graduate student at the University of Oxford. These are their personal views.

Comments are welcome at theirview@livemint.com

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Published: 17 Sep 2014, 04:45 PM IST
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