The new RBI Governor has made it amply clear by now that his priority would lie in fighting inflation, unlike his predecessor who chose to walk through the delicate balance between growth and price concerns and ended up losing at both the fronts. Under his leadership, RBI is mustering all its resolve to regain control over inflation, even if it entails raising policy rate by a few notches and hurting growth in the short run. In a recent interaction with the Governor, many market analysts supported this view as they felt underlying inflationary momentum across sectors has picked up in recent months. If that is so then Governor Raghuram Rajan has an easy choice on October 31 as both WPI and new CPI headline inflation numbers have picked up in September, somewhat in line with its own projection made, on September 20, in the mid-quarter review.
Is the choice going to be that easy given the economy is decelerating fast, quarter-on-quarter? Is the level of repo rate low enough to warrant a hike? According to many market analysts the answer is an unequivocal yes, as they focus more on the new CPI inflation. For RBI though, it still remains an uncharted territory. Caught between wide divergence between the WPI and CPI inflation, RBI is treading carefully.
For the central bank, matters get more complicated as core-CPI inflation remains stickily high in a 8.2%-8.6% range barring a couple of months, a feature contrary to what one would expect in six straight quarters of below-trend growth; the disinflationary feedback, by contrast, is clearly visible from down-trending WPI inflation for over a year as weakening demand filters through. The CPI’s limited history precludes informational insights on its linkages with other macroeconomic variables, a serious constraint for monetary policy adjusting to retail price inflation as a first. The context is delicate, the backdrop wary and stakes high. Can history offer some perspective?
It’s important to understand why the larger focus upon CPI inflation vis-à-vis WPI inflation in recent times. This is quite new, going back about two years. Its genesis lies in the failure of RBI to tame inflation, raging since 2009-10. Headline WPI inflation averaged 9.8% monthly in 2010 and 2011, with retail inflation (as per the CPI-IW index) a percentage point higher. Crucially however, CPI inflation averaged 11% monthly from October 2008 to end-2009, peaking at 16.2% peak in January 2010.
Monetary policy, in tightening mode before the 2008 crisis with the policy rate at 9%, sharply eased in response to the crisis: RBI’s benchmark repo rate almost halved over October 2008-April 2009 to 4.75%. Food prices—more reflected in the CPI—began to rise by June 2009, pushing retail inflation into double-digits; WPI inflation was relatively muted from base and global commodity price effects, but gained momentum in the second half of 2009. RBI then argued that monetary policy had little role to play in the face of supply shocks, as the drought was; its stance was more guided by the global situation, growth concerns and WPI inflation. By March 2010, WPI inflation crossed into double-digits, inflation became generalised over 2010-11 as food inflation spilled over into a wage-price spiral with a swift economic rebound in these two years.
This episode, or the persistence of inflation despite 13 interest rate increases in two years—RBI began to tighten from March 2010, lifting its policy rate from 4.75% to 8.5% by end-2011, mostly in 25 bps steps—sparked a debate about how much to tighten, whether the WPI was an appropriate indicator and if CPI should not replace it instead. Initially, most of the debate and discussions centered around the idea that the central bank should raise its WPI anchor to a higher level than 5%. RBI strongly defended its position not to do so. But somewhere down the line, the advisory changed track to move in the direction of new CPI from January 2012.
But was it under-measured inflation as per the WPI? Could it have been insufficient monetary tightening instead? A two-decade history of inflation and interest rate movements offers another perspective on this (see chart). The striking observation in historical context is that RBI’s policy rate, aligned to core-WPI inflation, remained well below headline WPI inflation throughout 2010-11, in marked departure from at least two-decade movements. Historically, RBI has set its benchmark rate well above overall WPI inflation, possibly reflecting cognizance of other price indicators, monetary aggregates, output gap and so on.
By this yardstick, it would appear that monetary tightening in 2010-11 was insufficient relative to overall inflation, output and other macro conditions. While the global financial crisis was a major shock, it is likely RBI did not adequately factor in domestic demand developments, notably, the exceptional fiscal expansion and a V-shaped recovery—GDP growth was then measured at about 8.4% in 2009-10 and 2010-11. After all, WPI-guided monetary policy decisions haven’t really been wrong before. That there might have been monetary policy errors was recently acknowledged by both former Governor D Subbarao and former deputy governor Subir Gokarn.
This is plausible, as developments from 2012 would suggest. As the chart shows, from January 2012, the repo or policy rate adjusts above headline WPI inflation, remaining so throughout 2012. GDP growth also slid to around 5% in 2012. By October 2012, WPI inflation was down to 7.3%, despite 20%-plus exchange rate depreciation from October 2011-August 2012. In April 2013, headline WPI inflation fell to 4.8%. Core-WPI inflation, the demand gauge, almost halved from 5.2% in October 2012 to 2.8% in April 2013, falling further to 1.9% in August before its recent pick-up to 2.1% in September, reflecting exchange rate and diesel prices pass-through. The GDP deflator, the broadest inflation measure, also fell to 5.6% in April-June from 7.4% the previous quarter.
The significant point from this narrative is that with appropriate interest rate adjustments in 2012, the relationship of inflation with other macroeconomic variables like output, income and employment is once again restored. The visible slowdown of industrial production, especially consumer goods, retail sales, etc. buttress this; in 2013, even rural wage growth is reported slowing. This implies that the WPI’s links with macroeconomic variables didn’t really break down in the high inflation episode, but just that monetary policy wasn’t tight enough as the twenty year long monetary history would suggest.
In this light, it would be risky for RBI to base its monetary response upon the new CPI, whose linkages with other macroeconomic variables are not yet understood and when growth was as weak as 4.1% two quarters ago. The vast difference in the two inflation indicators vis-à-vis the wider economic conditions suggest caution at this point. Understandably, the central bank is chary and anxious to restore its inflation fighting credentials; it would rather err on the side of over-tightening than be lax second time round. History suggests that this time it is different.
The author is a New Delhi-based macroeconomist