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, and 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