We are all inflation-targeters now, at least since RBI published the Urjit Patel committee report on strengthening the monetary policy framework in India. Inflation, at over 10% annually for the last six years, is something that definitely needs fixing. But is inflation-targeting (IT) the right formula?
In order to understand that important question, one needs to know the determinants of inflation. The US gave up on the notion that the growth of money supply determines inflation sometime in late-1983, when it stopped reporting the eagerly watched money supply numbers on Thursday afternoons. At that time, US CPI inflation had already come down sharply from its double digit peak of 13.5% in 1980 to around 3%. After the peak of 5.4% experienced in the Kuwait crisis (oil price) years of 1990-91, US CPI inflation has averaged 2.4%, with a peak of 3.8% in the commodity peak year of 2008 and -0.3% in the commodity trough year of 2009.
Now, the US does not have inflation-targeting as a policy, and may have had a loose, de facto targeting policy in the last decade. But it would be erroneous to conclude that the US experience supports the targeting idea, just as it would be equally erroneous to conclude that all the Q (quantitative easing) liquidities have any impact on US inflation. Whether the Qs have an effect on asset prices remains an open question.
Do other countries? experiences support the notion that IT has been effective? The Patel report documents that 14 countries adopted IT between 1990 and 2000. The example of inflation in Chile declining from 24% in 1990 to 4.4% in 2007 and in Czech Republic, declining from 10.7% 1998 to 2.9% in 2007 is cited by the report as success stories. India, of course, did not have inflation-targeting but nevertheless CPI inflation did decline from 11.2% in 1990 to 4.4% in 2005 and 6.2% in 2007. The correlation of India?s non-targeted inflation rate with the targeted Chilean and Czech Republic inflation rate is a high 0.73 and 0.66 respectively!
The fact remains that the last six years have witnessed a record high of over-10% CPI inflation rate and RBI is rightly concerned in trying to bring it down by whatever means, even a targeting scheme with a dubious record. There are other suggestions, besides targeting, for bringing down inflation. For example, the IMF argues for a raising of repo rates until the cooling is in place. It further argues, as do many others in India, that if only RBI had been vigilant and raised rates earlier, inflation would not have stayed persistently above-10% levels.
The evidence suggests that the IMF (and its followers) have not quite understood the dynamics of inflation in India. Just look at the record?on every occasion RBI raised rates in the last five years, the inflation rate went up! So, empirical IMF logic would suggest that the best way for inflation to be brought down in India is not by targeting, not by raising rates, but by lowering rates. Sounds crazy. But hold that thought until we briefly review the inflation experience in India, it?s possible determinants, and what the inflation situation is today?and is likely to be in the future
Prior to 1972, Indian inflation was determined primarily by what happened in agriculture. Somewhat surprisingly, the average CPI inflation between 1960-1972 was as little as 4%. The end-point, 1972, is deliberately chosen because of the quadrupling of the price of oil in October 1973. Between 1973 and 1996, inflation averaged 9.1% and then entered a stable zone of 5.4% for the next 8 years (1997-2004). The importance of agriculture declined in this period to less than 25% of the GDP. But then a curious thing happened?Indian inflation became dependent on agriculture, despite significant improvement in yields, and production, and food stocks. The period after 2004 is of course coincident with the UPA?s persistent efforts at political engineering, an engineering dedicated to win the rural vote via higher administered ?support? prices for agricultural crops. These are not support prices, but rather maximum prices available to the farmers with the highest surplus, i.e., the rich farmers. Landless laborers lost out in this pro-rich populist UPA game. The result?overall inflation, very high; cost of capital, very high; and overall disgust with the ruling dispensation, very high.
But there is a silver lining that comes too late for the Congress but not for the economy which, unlike political parties, will be there forever. Sometime in 2013, the anti-Sonia populism technocrats prevailed, no doubt helped by the in-your-face defeats of the Congress in Assembly elections. After rising by an average 13.5% in the previous six years (2007-2012), agricultural procurement prices (APP) rose by only 6% in calendar year 2013. In 2012, the index rose at a 16% rate; historical data suggests that this 10 percentage point decline in APP should lead to an average CPI inflation rate of 7.5% in 2014.
RBI?s target CPI inflation rate for December 2014 is 8% and 6% for December 2015. For three months ending in February 2014, the annualised rates of CPI and WPI inflation are 1.1% and -3.0%, respectively. This 3-month CPI rate is the lowest since the -0.3% recorded in August 2003. As the graph suggests, both CPI and WPI maybe reflecting the beginning of a structural change in Indian inflation. To be above the RBI target of 8% in December 2014, CPI inflation would have to average above 10% for the rest of the calendar year. Of course, anything can happen, but the likelihood of RBI?s 2014 target not being met is close to zero, and of CPI inflation reaching the December 2015 target of 6% twelve months earlier is, in my humble opinion (or as Kejriwal would say, meri kya aukat hai), very high. Interest rate cut, anyone?
The author is chairman, Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla
