What are considered to be cost-push factors, such as minimum support price, are mostly the delayed response to demand overheating
Examining various agricultural prices, one of us (Manur) had concluded that hikes in the minimum support price (MSP) are not the root cause of India?s ongoing high inflation (?Procurement price inflation bogey?, FE, March 28, http://goo.gl/49TD9). This view has been severely criticised by Ghosh and Arora (?Don?t blame MSP alone?, FE, April 2, http://goo.gl/0P4xs). This article is a rejoinder to their criticisms.
Basically, the article sought to assess whether India?s inflation is demand-driven or cost-driven – more specifically, by the policy intervention of MSP, generally considered to be a cost-push factor. The approach taken was as follows. Divide the commodities into two groups: those with MSP (group A) and those without MSP (group B), the control group. If MSP is the critical and causal factor underlying food inflation, then the inflation rate should be, on average, higher for group A than group B. However, if this is not the case, then inflation should then be attributed to demand pressures, and not to MSP.
For six items with MSP, over the chosen five-year period (October 2007-October 2012), the average price change was 56%, while for 13 items without MSP it was 76%. The main fact to note is that both groups have high (compounded) inflation rates of 9.4% and 12.4%, respectively, indicating generalised excess demand, with non-MSP group B higher. Only if the inflation rate was higher for group A, and statistically significant, can one claim that MSP is responsible for India?s high inflation. The raw data loosely suggests otherwise.
Ghosh and Arora criticise this conclusion. They contend that what matters in identifying the source of inflation is the inflation contribution of the two groups, not their respective inflation rates. The inflation contribution of any item is its inflation rate times its weight in the price index. Thus, if group A has a weight of 50% and an inflation rate of 8% while group B has an inflation rate of 10% and a weight of 5%, their inflation contributions are 4 percentage points and 0.5 percentage points, respectively.
Looking mechanically at inflation contributions, suppose MSP items predominate, it could be argued that the bulk of inflation is cost driven. RBI, to a large extent, also breaks inflation down into cost versus demand side factors. However, relevant macroeconomic theory eschews both this cost versus demand approach and an overdue emphasis on inflation contributions. These approaches are misleading because what appears to be exogenous cost factors are, generally, the delayed response to demand overheating.
Drawing upon concept of the Inflation Adjusted Phillips Curve (IAPC), the more meaningful breakdown of inflation is into the following: one component due to inflation adjustment and the other component due to the current demand-supply imbalance in the economy (?Both overheated and lacking heat?, Moorthy, FE, March 18, for an elaboration of this breakdown, http://goo.gl/bQUhu). The IAPC can largely explain the changes in MSP. Indeed, Surjit Bhalla?s discussion, which Manur has cited at length, points towards the MSP price hikes as being a manifestation of the IAPC process at work. Unfortunately, by getting fixated on the weights and inflation contributions of the MSP and non-MSP group, Ghosh and Arora have failed to comprehend the role of prior demand overheating in pushing up MSP.
The authors also do some laborious calculation to show that the inflation contribution of non-MSP group is negative for some years. These calculations are not relevant since even annual inflation data are noisy. What counts for our conclusion is the multi-year average: to reiterate, the average inflation rate is higher for group B items than for the MSP group A.
The distinction in monetary economics between absolute and relative prices, and between overall and sector-specific inflation rates, is crucial to understand the classical view that inflation should not be attributed to special factors, say, agriculture. (?The Rudderless Bank of India?, Moorthy, FE, March 12, 2012, http://goo.gl/mL126). To elucidate this classical distinction, the accompanying table compares inflation rates and the relative price of food to non-food for India and the Philippines for a five-year period.
What do the data indicate? Looking only at India, the policymakers concluded that our high inflation is due to double-digit food inflation, which, in turn, was attributed by former RBI Deputy Governor Subir Gokarn to changing dietary habits and supply constraints. This food-centric view has been reiterated by the latest Economic Survey, March 2013. It states upfront in its introductory chapter ?Elevated food inflation remains an area of concern? (See Pg 1, 17, 18) and in many places inside the text too.
However, the comparison between India and the Philippines clearly shows the error in this viewpoint. The Philippines is well suited for a comparison with India. Our closest competitor in the call centre business, it has edged ahead over the last few years. The peso/dollar exchange rate has traded places with the rupee over the last decade, rising from about 51 pesos to a dollar in 2006 to around 42 pesos to a dollar last year. With a very strong balance of payments situation, the Philippines debt has very recently been upgraded from junk to investment grade, while India may slip below.
Getting down to the inflation data, the share of food in the Philippines CPI is fairly close to India. With year 2006=100, the relative price of food to non-food is 1.14 for both countries, implying that India?s food situation is not special. In both countries, food inflation has been higher than non-food. However, the fundamental difference, which is very evident, is that India?s inflation is much higher (about four percentage points) for all categories: food, non-food or overall. These meaty facts are food for thought, and should be slowly digested.
Indeed, it is noteworthy that for the same relative prices, the Philippines?s 6.9% food inflation is lower than that of India?s 7.8% non-food inflation (see table). By repeatedly stressing that India has high food inflation, our policymakers and rate-cut lobbyists have been missing out on, or camouflaging, the critical fact that overall inflation is high.
It should also be noted that the Philippines is not an isolated case. For all Asean countries, the relative price of food to non-food is generally close to or higher than India: with 1.10 for Taiwan, 1.15 for Korea, 1.16 for Malaysia, 1.34 for Thailand, and China a high of 1.51. However, their overall inflation is much lower.
The above analysis is up to year 2011. Looking at inflation from the new all-India composite CPI reinforces these facts. For 2011 and 2012, the overall inflation rate has averaged 9.9%, with food 10.1%. A simple calculation reveals that non-food inflation (of which services is about half) has correspondingly averaged 9.6% over the last two years. Although the economy has slowed down, inflation across the board remains high.
As for monetary policy, it is certainly the case that RBI has tightened in 2010 and 2011, and this has contributed to the slowdown as they emphasise. However, evaluated over the whole five-year period, policy has been too lax. Further, after recent easings, including the 25 bps repo rate cut to 7.25% on May 3, both short and long rates are still about 200-300 basis points below expected and actual inflation. In short, despite the earlier tightening moves, monetary policy is still not tight enough.
In passing, at the end of their article, Ghosh and Arora arbitrarily proposed a macroeconomics policy pentilemma. As a matter of fact, there is no clear logical basis for a set of concrete policy choices beyond the well-known trilemma or trinity. To put it mildly, their proposed pentilemma is preposterous!
Vivek Moorthy is a professor of economics at IIM Bangalore. Anupam Manur is a research associate at IIM Bangalore
