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Renu Kohli On Inflation

While the RBI has signaled its intent to adopt the CPI as its monetary policy anchor by publishing CPI inflation forecasts, there are significant issues with using CPI that should make the central bank wary. The CPI data series is less than three years old, providing only around 20 observations so far, which is likely an insufficient time-series for forecasting inflation two quarters ahead. Additionally, a large portion of headline CPI inflation, such as food and fuel prices, tends to be very volatile and unpredictable, depending on factors like global oil prices, weather conditions, and trade policies, rather than economic decisions. This raises questions around the robustness and predictability of CPI inflation forecasts.

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Dipesh Jain
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0% found this document useful (0 votes)
82 views8 pages

Renu Kohli On Inflation

While the RBI has signaled its intent to adopt the CPI as its monetary policy anchor by publishing CPI inflation forecasts, there are significant issues with using CPI that should make the central bank wary. The CPI data series is less than three years old, providing only around 20 observations so far, which is likely an insufficient time-series for forecasting inflation two quarters ahead. Additionally, a large portion of headline CPI inflation, such as food and fuel prices, tends to be very volatile and unpredictable, depending on factors like global oil prices, weather conditions, and trade policies, rather than economic decisions. This raises questions around the robustness and predictability of CPI inflation forecasts.

Uploaded by

Dipesh Jain
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Fighting inflation: then and now

Renu Kohli | Updated: Oct 25 2013, 16:35 IST Print


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would be risky for the RBI to base its monetary response upon the new inflation index, whose linkages with other macroeconomic variables are not yet understood
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 Ra an has an easy choice on !ctober "# as both $%I and new &%I headline inflation numbers have picked up in 'eptember, somewhat in line with its own pro ection made, on 'eptember (), in the mid*+uarter review. Is the choice going to be that easy given the economy is decelerating fast, +uarter*on* +uarter, Is the level of repo rate low enough to warrant a hike, -ccording to many market analysts the answer is an une+uivocal yes, as they focus more on the new &%I inflation. .or RBI though, it still remains an uncharted territory. &aught between wide divergence between the $%I and &%I inflation, RBI is treading carefully. .or the central bank, matters get more complicated as core*&%I inflation remains stickily high in a /.(0*/.10 range barring a couple of months, a feature contrary to what one would e2pect in si2 straight +uarters of below*trend growth3 the disinflationary feedback, by contrast, is clearly visible from down*trending $%I inflation for over a year as weakening demand filters through. The &%I4s limited history precludes informational insights on its linkages with other macroeconomic variables, a serious constraint for monetary policy ad usting to retail price inflation as a first. The conte2t is delicate, the backdrop wary and stakes high. &an history offer some perspective,

It4s important to understand why the larger focus upon &%I inflation vis*5*vis $%I inflation in recent times. This is +uite new, going back about two years. Its genesis lies in the failure of RBI to tame inflation, raging since ())6*#). 7eadline $%I inflation averaged 6./0 monthly in ()#) and ()##, with retail inflation 8as per the &%I*I$ inde29 a percentage point higher. &rucially however, &%I inflation averaged ##0 monthly from !ctober ())/ to end*())6, peaking at #1.(0 peak in :anuary ()#). ;onetary policy, in tightening mode before the ())/ crisis with the policy rate at 60, sharply eased in response to the crisis< RBI4s benchmark repo rate almost halved over !ctober ())/*-pril ())6 to =.>?0. .ood prices@more reflected in the &%I@began to rise by :une ())6, pushing retail inflation into double*digits3 $%I inflation was relatively muted from base and global commodity price effects, but gained momentum in the second half of ())6. RBI then argued that monetary policy had little role to play in the face of supply shocks, as the drought was3 its stance was more guided by the global situation, growth concerns and $%I inflation. By ;arch ()#), $%I inflation crossed into double*digits, inflation became generalised over ()#)*## 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 #" interest rate increases in two years@ RBI began to tighten from ;arch ()#), lifting its policy rate from =.>?0 to /.?0 by end* ()##, mostly in (? bps steps@sparked a debate about how much to tighten, whether the $%I was an appropriate indicator and if &%I should not replace it instead. Initially, most of the debate and discussions centered around the idea that the central bank should raise its $%I anchor to a higher level than ?0. 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 &%I from :anuary ()#(. But was it under*measured inflation as per the $%I, &ould it have been insufficient monetary tightening instead, - two*decade history of inflation and interest rate movements offers another perspective on this 8see chart9. The striking observation in historical conte2t is that RBI4s policy rate, aligned to core*$%I inflation, remained well below headline $%I inflation throughout ()#)*##, in marked departure from at least two*decade movements. 7istorically, RBI has set its benchmark rate well above overall $%I inflation, possibly reflecting cogniAance of other price indicators, monetary aggregates, output gap and so on. By this yardstick, it would appear that monetary tightening in ()#)*## was insufficient relative to overall inflation, output and other macro conditions. $hile the global financial crisis was a ma or shock, it is likely RBI did not ade+uately factor in domestic demand developments, notably, the e2ceptional fiscal e2pansion and a B*shaped recovery@GC% growth was then measured at about /.=0 in ())6*#) and ()#)*##. -fter all, $%I*guided monetary policy decisions haven4t really been wrong before. That there might have been monetary policy errors was recently acknowledged by both former Governor C 'ubbarao and former deputy governor 'ubir Gokarn.

This is plausible, as developments from ()#( would suggest. -s the chart shows, from :anuary ()#(, the repo or policy rate ad usts above headline $%I inflation, remaining so throughout ()#(. GC% growth also slid to around ?0 in ()#(. By !ctober ()#(, $%I inflation was down to >."0, despite ()0*plus e2change rate depreciation from !ctober ()##* -ugust ()#(. In -pril ()#", headline $%I inflation fell to =./0. &ore*$%I inflation, the demand gauge, almost halved from ?.(0 in !ctober ()#( to (./0 in -pril ()#", falling further to #.60 in -ugust before its recent pick*up to (.#0 in 'eptember, reflecting e2change rate and diesel prices pass*through. The GC% deflator, the broadest inflation measure, also fell to ?.10 in -pril*:une from >.=0 the previous +uarter. The significant point from this narrative is that with appropriate interest rate ad ustments in ()#(, 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 this3 in ()#", even rural wage growth is reported slowing. This implies that the $%I4s links with macroeconomic variables didn4t really break down in the high inflation episode, but ust that monetary policy wasn4t 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 &%I, whose linkages with other macroeconomic variables are not yet understood and when growth was as weak as =.#0 two +uarters ago. The vast difference in the two inflation indicators vis*5*vis the wider economic conditions suggest caution at this point. Understandably, the central bank is chary and an2ious to restore its inflation fighting credentials3 it would rather err on the side of over*tightening than be la2 second time round. 7istory suggests that this time it is different. The author is a Dew Celhi*based macroeconomist

Column: A shaky base


Renu Kohli | Updated: #o$ 1% 2013, 16:53 IST Print
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of data, questionable predictability are among the many issues with CPI that should make RBI wary
In its recent monetary policy statement on !ctober (6, Reserve Bank of India published its first ever forecasts of consumer price inflation. This is a significant development. .or one, it confirms the central bank4s intent to adopt the &%I as its monetary policy anchor. The appearance of retail inflation pro ections, concurrent with the $%I inflation as the official anchor, has muddled the monetary policy signals emerging from ;int 'treet. But this is a

secondary matter. %rimarily, the &%I inflation forecasts themselves raise considerable unease. Dot because of the underlying model from which the forecasts might be obtained, or that they might be sub ective predictions. The key point is the data available to forecasters< Is there sufficient information for guiding an optimal monetary policy, 7ere, the &%I forecasts raise a number of +uestions. The first of these is to do with data ade+uacy. The composite &%I is less than three years old, starting from :anuary ()##. To date, i.e., until !ctober, the &%I inflation data points numbered ust twenty two. RBI4s &%I* inflation forecast could then have been based upon twenty observations perhaps. Is that a long enough time*series for forecasting inflation two +uarters ahead, %erhaps the current series was e2trapolated backwards with statistical techni+ues like bootstrapping to overcome data deficiency. 7ow robust are these forecasts in that case, !ther than insufficient data, the predictability of a significant chunk of headline &%I inflation is +uestionable. The &%I forecasts represent a guess of some prices, viA. food and fuel, which tend to be very volatile. By construction of weights, this variable component is as high as 1)0 in the price inde2. $hat view would the &%I forecasts incorporate of global oil prices and their pass*through to domestic consumers, not really an economic decision, ;oreover, food and vegetable prices fluctuate sharply from reasons as diverse as e2cess or deficit rainfall, other weather vagaries and whether some farm products should be imported or e2ported, again a political decision. - forecast of this component could be e2ceedingly complicated and embed a large capricious factor, potentially enlarging the gap vis*5*vis actual outcome. -part from the three*fifths variable component where supply shocks dominate, 6.>>0 weight of the balance &%I inde2 is for house rents, which are largely imputed. This is an issue where EFthere could be concerns about the efficacy of their measurement,G noted the former RBI Governor, C 'ubbarao. 7e added that if these were to be e2cluded, as several other central banks do, this would leave the &%I significantly bereft in terms of coverage and information content. Then again, the &%I is geographically sensitive, according to %ronab 'en, chairman, Dational 'tatistical &ommission and former chief statistician, a susceptibility which imparts inherently high risk for aggregate monetary policy decisions. By far, the greatest concern is of forecasting a price series that has yet to stabilise. This is a point noted by both current and former RBI Governors, Raghuram Ra an and C 'ubbarao in recent months, suggesting the &%I series is possibly still under observation by the central bank. It has also to prove robust and dependable. .or e2ample, even when prices of volatile components fluctuate sharply, they tend to return to the previous level within a relatively short span. $e do not see such mean*reversion in the &%I series so far. -lternately, could there be a secular upward trend, i.e., a shifting mean, !ther than that comple2 processes such as these need pinning down if they e2ist, the danger is of forecasting inflation when the price level may be deviating from its long*run behaviour. -part from stability issues, the &%I4s relationship vis*5*vis key macroeconomic variables central to the monetary policy decision is not yet known or understood. In the current

macroeconomic uncture for instance, the fact that contractionary impulses from declining domestic demand are not reflected in retail price inflation, in marked contrast to the much* older $%I inflation series, raises +uestions about its coordination with other economic trends. The persistence of core*&%I inflation in the /.(*/.10 range coe2ists rather uneasily with indications observed from the output*input price indices of 7'B&4s %urchasing ;anagers Inde2, lowered capacity utilisation and inventory levels, falling sales, etc. It defies the logic of pass*through dynamics where pricing power is smaller when demand conditions are weak3 that output could be under*measured, e.g., industrial production, is countered by the higher*fre+uency, disaggregate measures of economic activity. The fact that RBI has not really been forthcoming in e2plaining the wholesale*to*retail prices transmission process, the magnitudes as well as the lags, suggests the second*round inflation dynamics is still under study at the central bank. -ll this lead one to conclude the new &%I series is still evolving. - forecast of how the general price level will evolve over a specific horiAon is an essential part of the central bank4s decision*making process. It forms the basis for framing the best possible monetary policy. This however depends upon optimal forecasts, consumer prices in this instance. The numerous data, information and linkage issues surrounding the new &%I series suggest the foundations of RBI4s first*ever &%I*inflation pro ections could be rather shaky. -n une+uivocal answer whether these can guide optimal policy responses is hard in the light. Is the central bank not risking its credibility by this adventure then, The author is a Dew Celhi*based macroeconomist

Watch out for the CPI rateshock


Renu Kohli | Updated: Oct 01 2013, 08:20 IST SUMMARYRBI

using CPI instead of PI will lock the economy into a very high policy rate in the short! to medium!term
- +uestion dotting the financial market space once again is if RBI is increasingly leaning towards retail inflation for monetary responses, preparing the ground for dumping the conventional $%I inde2 in favour of the new &%I inde2 to anchor inflationary e2pectations. $hat if headline $%I inflation declines from a good harvest but &%I inflation remains high, $ill RBI ignore any seasonal correction in the $%I and raise the policy rate further to align it closer to the new &%I, These +uestions, revolving around the $%I versus &%I inflation debate, have led to a fair degree of uncertainty in recent weeks as to what will drive future monetary policy action. -lthough the new RBI Governor, Raghuram Ra an has already said that clarity on this matter will emerge once the Emonetary policy frameworkG committee 8&hair, deputy governor Ur it

%atel9 submits its report in three months time, many market analysts have raised their future repo rate guidance, anticipating RBI will eventually Ewalk the talkG and make the transition to adopt the new*&%I as its future monetary policy anchor. The fall out of such forward* looking policy guidance by the analyst community has run tangential to the central bank4s own guidance on a neutral policy rate stance. The resultant steepening of the yield curve at the long*end has made RBI uneasy3 the devolvement in primary auctions was a case in point. The moot +uestion is< $hat leads the market analysts4 conclusion that RBI, under a new Governor, will end the $%I*&%I uncertainty and make a formal transition even when the Emonetary policy frameworkG committee has barely got off the ground, The answer, somewhat strange, is analysts4 belief that the new Governor4s mind is made up in favor of the new &%I and the transition will be formalised in the new, forthcoming Emonetary policy framework.G This appears a strange case of market uncertainty where the new Governor4s stated policy position has few takers, but his perceived future position has gained sufficient credibilityH Three distinct pronouncements by the new Governor, which analysts understand to be convincing, specific leads, have shaped their views. The first@when the new Governor took over at ;int 'treet@was the announcement of the &%I*Inflation Inde2ed 'avings &ertificates for retail investors to be issued by end*Dovember. This looked perple2ing with $%I*inde2ed bonds already in the market3 while interested buyers would focus upon the higher returns from such bondsIcertificates, the declaration caused confusion from a monetary policy perspective. ;ore importantly, this pronouncement seemed to e2tend legitimacy to a price inde2 whose reliability and stability was under scrutiny by the very institutionH :ust a month ago, e2* Governor, C 'ubbarao, had categorically stated the new*&%I4s limitations, e2plaining why RBI must stay with the $%I while making a calibrated transition, in his last speech 8E'tatistics in RBI4s %olicy ;aking* &onceptual and Jmpirical IssuesG, -ugust ")9. Those who carefully read the speech were fair to conclude the $%I*&%I uncertainty was settled where monetary responses mattered and, therefore, further speculation on this was unwarranted. Dot surprising then that the &%I*inde2ed certificates surprised many, while bringing alive the $%I*&%I debate once again. 'ome interpreted this as a signal that, unlike his predecessor, Ra an is more comfortable with the new*&%I and ready to adopt it as a policy anchor. Two, these e2pectations gained further ground with the surprise (? bps repo rate hike at the RBI4s mid*+uarter review3 this was linked, but not e2plicitly, to high retail inflation and its role in entrenched inflationary e2pectations. The third clinching lead is the recent reference to new &%I*core inflation 8viA. &%I stripped of food, fuel prices9 by the Governor on the sidelines of an event< this has become a market buAA * the die seems cast, as it were, by RBI to formalise its policy link vis*5*vis the new &%I.

!ne must again emphasise that these are not really clinching pieces of evidence, but mere perceptions of a segment of market analysts driven by an2iety to see through the transition. Dor did Governor Ra an ever say anything that materially deviated from RBI4s stated position on the matter. Issuing &%I*linked certificates, for e2ample, could be for the limited purpose of weaning retail investors from gold@these might be ust certificates, not market* traded bonds@so it may be premature to attach much significance in a monetary policy formulation conte2t. Kikewise, the 'eptember () rate hike could well be ustified by an anticipated reversal in $%I headline inflation. -nd the reference to &%I*core shouldn4t have been surprising as RBI always looks at all kinds of inflation. Importantly, it is a bit naLve to think that the Emonetary policy frameworkG committee will overlook the new*&%I4s limitations pointed out by the former RBI Governor as these are very specific< lack of robustness, dominance of supply side factors and inade+uate data coverage for services4 price indices. Deither do these become irrelevant with change of guard at ;int 'treet, nor do they change colour to align with a new policy frame workH These are purely data limitations that must be addressed, without which a robust policy framework would lack credibility. To highlight one such instance of data susceptibility, the core*&%I and core*$%I are plotted alongside. The core*&%I remains at around /0 since :uly ()#(@a prolonged period of #= months in which core*$%I inflation declined +uite sharply. $hat e2plains the relative stickiness of &%I*core 8comprising mostly services activities9 since :uly ()#(, $hy didn4t services4 inflation fall when the sector itself is witnessing sharp demand deceleration reflected in the successively weaker +uarterly growth numbers, -fter all, the services sector is unlikely to suffer from supply constraints, the traditional e2planation for food inflation. &an a wage*price push be e2planation enough, while the same isn4t true for the manufacturing segment, &an we rationally e2plain this behaviour, If not, is the data itself suspected, Is it possible the new &%I*core is overstating the true inflation, There isn4t an attempt to conclude anything here but only to highlight that without some credible answers to these emerging trends, it would be risky for the RBI to make any hasty transition to the new*&%I for monetary policy. $hile appreciating the new*&%I4s appeal@its core component measures inflations for services, almost two*thirds of India4s economy, hitherto missing from the conventional $%I@it is crucial to recognise that it is this very component that is under scrutiny< If it remains unrepresentative, as the e2*Governor noted, will the new*&%I ably fulfill all the robust features so essential for credible policy guidance, $hile the RBI4s focused fight against inflation and inflationary e2pectations to restore stability to the internal and e2ternal value of rupee is respected, we suggest the new Emonetary policy frameworkG committee e2tend its considerations to the new &%I4s limitations and factor in how much of a handicap these could be. .or articulating a red line in terms of the new &%I could run the risk of locking the economy into a very high policy rate regime in the short to medium*term if average food price inflation persists above #)0 as in

past few years, given supply constraints and unresponsive political economy, and services4 price inflation e2hibits stickiness at around /0, as the new &%I inde2 continues to evolve.

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