Inflation in India has remained stubbornly high. Late in January, RBI raised interest rates again. Some have complained that high interest rates have been choking growth. Others have argued that interest rate policy is ineffective in the current Indian context, where other factors are driving inflation. I argue here that RBI is doing things better than it ever has before. Not only is it being clear in its objectives, but it is also moving toward a consistent policy framework that has often been absent in the past: it seems that the days of ad hoc, and even muddled, monetary policy responses are coming to an end.
The role of the new leadership at RBI, which is manifesting itself in greater decisiveness and in organisational changes, is an obvious factor in shaping one’s optimism about India’s monetary policy. But there also seems to be an accumulation of technical experience and analysis that is helping to guide policymaking. As an example, consider the RBI working paper by Muneesh Kapur and Harendra Behera, published in 2012. This paper builds a small macro model (using quarterly data) to examine the interaction of monetary policy, inflation and growth. The authors consider all the possible factors that come up in media discussions of what has been driving inflation in India: oil prices, other commodity prices, minimum support prices (MSPs), the exchange rate, rainfall, and fiscal deficits.
Typical discussions of inflation in India focus on one or the other factor, and make assertions rather than checking their claims against the data. Even when the data are analysed, the exercise stops at observations of patterns or correlations. In fact, many of the potential culprits in the inflation process are themselves determined jointly with inflation and growth in a complex economic system replete with feedback loops. This is precisely what Kapur and Behera seek to model.
Of course, modelling a complex system means that the conclusions are not simple. But some things are easy to describe in broad terms. It seems that interest rate policy does have the expected impacts on inflation and output, albeit with estimated magnitudes that are relatively small. The model not only supports this conclusion, but it estimates the lags with which effects occur, and the magnitudes of effects in the short run and over longer periods. The model also suggests that higher MSPs feed inflation, but themselves may have been influenced by increases in overall price