The Reserve Bank of India (RBI), in its monetary policy review on October 30, maintained the repo rate at 8%. Despite revising its 2012-13 GDP growth forecast downwards to 5.8% from 6.5% projected in July, the central bank refrained from reducing rates as inflation remains above 7.5%. This persistence in inflation, based on the wholesale price index (WPI), can partly be explained by sustained pressure on food prices and hikes in administered fuel prices. What is disconcerting, though, is that even non-food manufacturing inflation (core inflation), which indicates underlying demand-side pressures in the economy, continued to be high at 5.6% in September.
Non-food manufacturing inflation, which is obtained by excluding food and fuel from the overall price index, is not directly influenced by supply-side shocks, such as weak monsoons, high global crude oil prices or administered fuel price hikes. Therefore, RBI uses it as a proxy for measuring domestic demand-side pressures on inflation. Why is non-food manufacturing inflation rising, when demand growth, as reflected in GDP growth, is weakening? International evidence suggests this inconsistency can be attributed to a combination of two factors. First, core inflation tends to follow movements in economic growth with a lag. Second, one-time cost increases such as currency movements, changes in tax structure and administrative price hikes can distort core inflation movements.
As frequent price revisions involve administrative and other costs, firms change prices only after carefully evaluating demand trends and potential reactions of their competitors and customers. As a result, prices tend to be slow to adjust to changes in demand and core inflation follows growth cycles with a lag. In India, the lag between changes in GDP growth and core inflation has historically been around one year (see chart). For example, as GDP growth slowed to 6.7% in 2008-09, core inflation fell sharply in the following year. The sharp decline in core inflation in 2009-10 can be seen even if one excludes prices of basic metals, which collapsed completely during the global financial crisis. In 2009-10, the CRISIL Core Inflation Indicator (CCII), which does not include prices of basic metals, fell to 4.2% from 5.2% in the previous year. Subsequently, as government stimulus lifted growth to 8.4% in 2009-10, core inflation surged back to over 6%.
This one-year lag indicates that average core inflation this fiscal would be much lower than in 2011-12. This is because GDP growth fell to 6.5% last