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Why Moderate Inflation is a good thing

By Prakhar Misra

Inflation is not always bad for the economy. Some amount of inflation can aid the growth of an economy.

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In economics and in public discourse, inflation is a highly debated term spurring very extreme emotional responses. The media reports tend to suggest, albeit subtly, that inflation is a bad thing and that rising inflation is a cause of concern that needs to be dealt with immediately.

However, that is not true. Inflation, like all other Economic concepts is one that is beneficial if maintained in balance. Too high or too low inflation can be problematic. The costs of a deflationary economy are all too clearly seen in Europe now and in Japan since the 1990s.

Inflation is basically a resultant of supply and demand of money in relation to the amount of goods and services produced in an economy. If there is more money, the value of each unit of the currency is reduced. So, it makes the currency less valuable in effect causing a rise in price. But, there is a general consensus that some amount of moderate inflation in healthy for the Economy.

The first caveat of this wisdom lies in John Maynard Keynes’ description of “Paradox of thrift”. Keynes talked about this paradox with respect to savings rate and one way to go around it was to have some positive inflation. If there is no inflation and prices keep reducing, then individuals will keep delaying their spending which will lead to a fall in aggregate demand resulting in less production, layoffs and hence a decline in Economic growth. Hence, having a positive inflation rate helps in preventing such a situation.

In theory, inflation also helps in increasing production. More money means more spending which further translates to an increase in aggregate demand. This increase feeds into increasing production of goods in the country.  Infact, the Phillips Curves showed that by increasing inflation, we can successfully bring down unemployment levels. Although the 1970s era of ‘stagflation’ successfully rebutted this claim- but it was in the minds of many until then.

Higher inflation would lead to a price rise which would push companies to raise wages too. This might not be by full effect of inflation, but some sort of a rise can be expected. Thus, the rise in prices is more than the rise in wages as revision of wages takes time due to rewriting of contracts. This leads to an increase in the income of the firm which in turn helps in reducing the debt on loans and mortgages, effectively benefitting companies.

Inflation also helps governments reduce its debt burdens in 2 ways.Firstly, a healthy dose of inflation in the economy helps governments to collect more taxes. Even if the economy is stagnant, as long as there is inflation- the revenues of the government would continue to increase. Thus, even though inflation may devalue the currency – it may be offset by the excess money coming into the system that can be used to invest, build, hire more staff and spend in other areas of boosting economic activity. Secondly, the debt owed by governments to its lenders is not indexed to inflation. Thus, a higher rate of inflation reduces the value of the government’s debt, assisting the government in effectively paying back a lesser value than what it would otherwise.

But, all of these benefits are to inflation only if it is administered in moderation. Unless interest rates are higher than inflation rate, too much inflation leads to an inflationary spiral. Because of high prices- the profits of a company rise and so they hire more workers and increase wages. So, now goods are priced higher and people have more money to spend- and this leads to a successive increase in price rise. So, prices keep rising, but we don’t receive any benefit for our excess money. A deflationary spiral is equally dangerous, if not more. Prices reduce and people spend less because they delay their spending in expectation of prices to reduce further. This leads to companies laying off workers and cutting costs which further leads to a price-cut and so on.

For the first time in 2015, a Monetary Policy Framework was signed between the RBI and the Government of India which categorically states the following with respect to inflation: “The target for financial year 2016-17 and all subsequent years shall be 4% +/- a band of 2%.”

The target for January 2016, from the MPF, was to bring Inflation below 6% and the RBI has succeeded in doing that. Although, some Economists argue that even 5% is too high for India given that many countries in the world are hovering between 1-3% inflation rate.

A 3% inflation rate is generally accepted to be ideal, i.e, pushing a country to economic growth and preventing it from sliding into recession. While the inflation target of USA is set at 2%, countries like Zimbabwe had an inflation rate of 231 million % until very recently. So, Inflation can go either way depending on how well it is managed.

As the Austrian philosopher and economist Ludwig Von Mises said, “The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague, inflation is a policy.”

Prakhar Misra is a Chanakya Scholar at the Meghnad Desai Academy of Economics. He is an Alumnus from the GCPP. He tweets @prakharmisra .

 

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Price of Dosas

In an event hosted by the Federal Bank in Kerala, RBI Governor Raghuram Rajan was asked an unexpected question. Just when he had proclaimed that the central bank had won the war on inflation, a student asked him “In real life, I have a query on Dosa prices — when inflation rates go up, Dosa prices go up, but when inflation rates are lower, the Dosa prices are not lowered. What is happening to our beloved Dosa, sir?” she asked. His response revolved on technology. There has been no significant improvements in the technology involved in making dosas and thus, the prices have remained constant.

The same question was then posed in our GCPP forum. Here’s my response:

First and most importantly, inflation is the rate of change of prices and thus, when Rajan says inflation has come down, it means that the rate of change in prices have slowed (prices are increasing less rapidly).  It does not mean that prices have decreased and thus, the Dosa prices will not come down. So, the input costs and labour costs are still increasing, but at a slower rate, and thus, dosa prices stay the same.

Also, remember that prices do not react to inflation. Rather, the inflation number is an index of how prices of different commodities are moving.

Second, there is always a considerable lag in the macroeconomy for changes to take place. Even if all the input costs are decreasing, it takes time for it to travel through the economy. The more complex the product, the greater the lag for the transmission. The only things that you see where prices fluctuate often is farm produce (fruits and vegetables). This is so because there are very few people in the chain between the producer and the consumer. Thus, prices go up and down quite quickly reacting to demand and supply.

However, wages for labour are usually very sticky (read the concept of sticky prices by Keynes). No worker would agree to get a reduction in nominal wages even if the economy is in a deflationary (negative inflation). Newer contracts may be signed for lesser wages, but that takes time. Other aspects, such as rent, interest rate, etc will also not change immediately. Thus, our Dosa chap cannot reduce the price of his Dosa following a lowering of inflation.

Finally, prices of common commodities do come down after a sustained period of low inflation. When people expect inflation to stay low for a long period, they might be willing to renegotiate contracts. So, inflation expectations are also extremely important for this.

Raghuram Rajan is also correct in saying that technology plays a huge role. We can see in the field of electronic products that prices are continuously dropping or you are getting better models for the same price, which amounts to the same thing. That is due to the usage of better technology in producing these products.

There are a few restaurants in Bangalore who have optimized the technology, streamlined the production process for quicker turnaround and turned it into an assembly line production. They seem to offer dosas at the cheapest prices (Rs.20 in Jayanagar 4th block).

Anupam Manur is a Policy Analyst at the Takshashila Institution and teaches Economic Reasoning for GCPP students. He tweets @anupammanur

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Aftermath of Venezuelan Socialism

Venezuela is on the brink of a complete economic and political collapse, which has been building up since the early days of Bolivarian Socialism.

How does one know that things are going bad in Venezuela? – By the fact that there are no reliable ways of knowing it. Good economic data about Venezuela is conspicuous by its absence. It seems that President Maduro has made it State policy to not publish data. The last time that the Venezuelan central bank published inflation data was in January 2015 and it was 63% at that time, already the highest in the world. By the end of 2015, it was estimated by the IMF that inflation rates would have reached 275%

The Venezuelan economy and the government is in complete shambles and the only question is, as a Washington Post article points out, is which one will collapse first. A combination of bad policies and global situation has put Venezuela on the edge of the precipice.

The Venezuelan economy is driven by oil. In fact, it has the world’s largest oil reserves and like many oil-exporting countries today, is suffering due to low global crude oil prices. However, this is just the proximate cause. The seeds of destruction were sown with the extreme socialist measures taken by the late populist President Hugo Chavez. When oil prices soared in 2000s, it offered Chavez the funds to pursue a hyper-populist and socialist reforms in the economy. The Chávez government pursued a series of “Bolivarian Missions” aimed at providing public services (such as food, healthcare, and education) to improve economic, cultural, and social conditions. Very soon, fiscal spending ballooned in a view to retain loyal political support. Two cent gasoline, free housing, highly subsidized food from government controlled supermarkets and a whole range of such populist policies were practiced.

The first part of his inequality reduction was to conduct land reforms. Many productive agricultural lands were seized with the belief that land belongs to the state and not private individuals. With this move, a sizeable area of productive land previously owned by individuals were now sitting idle under government control, which led to reduction in food supply.

Further, the Chavez government set price controls on about 400 food items in 2003, in an effort to “protect the poor”. In March 2009, the government set minimum production quotas for 12 basic foods that were subject to price controls, including white rice, cooking oil, coffee, sugar, powdered milk, cheese, and tomato sauce. As it has been throughout history, price controls lead to massive shortages and to the creation of underground economies. In January 2008, Chavez ordered the military to seize 750 tons of food that sellers were illegally trying to smuggle across the border to sell for higher prices than what was legal in Venezuela.

As many socialist countries in the past will bear witness, one set of distortions introduced by the government will lead to many more and an attempt to correct those leads to further distortions. Price controls led to supply shortages. A few of the supermarkets that could manage to get its hand on essential supplies charged a price higher than what was stipulated. The government seized all of these supermarkets and the shelves have been empty ever since. This was a pattern that was found across all industries. A few examples:

  • Price controls caused shortages in the cement industry and led to a downturn in construction activities. The government nationalized the cement industry, including hostile take over of multi-national companies, which completely eroded business confidence in Venezuela, and led to a marked decrease in cement production.
  • The largest electricity producer in Venezuela was a private US firm, which was later nationalized. In 2013, 70% of the country plunged into darkness with 14 of 23 states of Venezuela stating they did not have electricity for most of the day
  • Similar cause and consequences were seen throughout Venezuela. Cable and telephone companies were nationalized – led to government censorship; Steel companies were nationalized – led to drop in production and capacity underutilization; Food plants – shortage of processed food; bank nationalization – a banking crisis in 2009-10, etc.

The biggest development that has led to present crisis is the complete take over off their biggest oil company. Even though the Petroleos de Venezuela was State-owned previously, it was at least run professionally before Chavez took over. People who knew what they were doing were replaced with people who were loyal to the regime, and profits came out but new investment didn’t go in. Accusations of nepotism were ripe. The result was that the company did not receive any new investments, which made the much-required technical upgradation impossible. Consequently, oil production in Venezuela declined by as much as 25% between 1999-2013.

The current economic crisis is a direct result of economic mismanagement in the past decade. Price controls led to reduction in supply and export bans led to shortage of foreign exchange needed for imports. The result is empty shelves on most retail outlets and a severe shortage of food supplies and being on the route to galloping inflation rates. Two to three hour-long lines in front of government owned supermarkets are not an uncommon sight. The government even deployed security personnel to kick out shoppers from the lines and introduced a two day per week limit for buying groceries.

People line up to buy food at a supermarket in San Cristobal, Venezuela. Source: Gateway Pundit

People line up to buy food at a supermarket in San Cristobal, Venezuela. Source: Gateway Pundit

 

Excessive government spending has led to deep fiscal imbalance and huge external debts. Many analysts are betting on a Venezuelan default by the end of the year, which will cripple the economy’s ability to rebound from the current crisis.

When faced with huge debt with no ability to raise revenues and limited borrowing opportunities, countries inevitably resort to one thing: printing notes and Venezuela has been doing it relentlessly. This has caused the Bolivar to drop 95% in the last two years, from 64/$ to 959/$ in the beginning of 2016. Given this, the IMF estimates inflation rate to touch 720% in 2016, which will no doubt intensify civilian protests in the country.

The Bolivar has dropped 93% in the past two years. Source: Washington Post

The Bolivar has dropped 93% in the past two years. Source: Washington Post

The need of the hour is economic reforms in order to dull the pain of an intensifying crisis. However, even if Maduro is prepared to bring in some much-needed reforms (which he probably is not), the opposition will not allow him. The opposition has just won the Congressional elections, which has given it a veto-proof majority, and they are determined to stall any plans that the ruling government may have.

The possibility of the opposition blocking Maduro’s reforms is a moot point. Maduro has far too much conviction in his socialist ideals and doesn’t look like he is too eager to change his policies. In fact, he passed a law, which has made it impossible to remove the Central Bank Governor that he has chosen and surely, he has chosen a remarkable candidate. He has chosen a central bank governor who doesn’t believe in the concept of inflation. As the Washington Post quotes the governor:

“When a person goes to a shop and finds that prices have gone up, they are not in the presence of ‘inflation,’ but rather parasitic businesses that are trying to push up profits as much as possible. Let me be clear, printing too much money never causes inflation. And so Venezuela will continue to do so”.

Please Mr Maduro, ask any Zimbabwean how this went down. Many economies have been on a similar path in the past and it is not pleasant. Venezuela will keep printing money until it runs out of money to buy printing paper. Hyperinflation (with inflation rates in millions) will ensue, before a complete economic and societal collapse, which will include asset stripping, rent seeking, and resource capture and hoarding by those who have power. In the end, generations in the future will suffer.

Anupam Manur is a Policy Analyst at the Takshashila Institution and tweets @anupammanur

Read about Brazilian economic crisis here and the Chinese debt burden here.

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The Macroeconomic Case for Central Bank Independence – II

Independence of the Central Bank results in low average inflation rates with minimal variance, which provides a conducive environment for high and sustainable growth.

Part I explored the inherent growth bias in an elected government and the reason why the government would be willing to tradeoff higher growth rates for a slightly increased inflation rate. The short run Phillips curve explains this phenomenon, while the Long Run Phillips Curve or the Expectations Augmented Phillips Curve shows that there is no long run tradeoff between the two variables in the long run and further, that any policy that tries to take advantage of the short run Phillips curve will end up with lower growth rate and a higher inflation rate. While fiscal policy still falls trap to the short run Phillips curve in many countries today, subjecting monetary policy to this line of thought will result in a stagnated economy with high inflation, which has very real economic costs to the population.

Milton Friedman, in all his wisdom, demonstrates the effects of monetary policy conducted with short term visions:

When the alcoholic starts drinking, the good effects come first; the bad effects come only the next morning, when he wakes up with a bad hangover – and often cannot resist easing the hangover by taking the ‘hair of the dog that bit him’.

The parallel with inflation is exact. When a country starts on an inflationary episode, the initial effects seem good. The increased quantity of money enables whoever has access to it – nowadays, primarily government – to spend more without anybody having to spend less. Jobs become more plentiful; business is brisk, almost everybody is happy at first. Those are the good effects.

But then the increased spending starts to raise prices. Workers find that their wages, even if higher in dollars, will buy less; businessmen find that their costs have risen, so that the higher sales are not as profitable as had been anticipated unless prices can be raised even faster. The bad effects are emerging: higher prices, less buoyant demand, inflation combined with stagnation.

As with the alcoholic, the temptation is to increase quantity of money still faster.. In both cases, it takes a larger and larger amount of alcohol or money, to give the alcoholic or the economy, the same ‘kick’.

— Milton Friedman in Money and Mischief: The Cause and Cure of Inflation.

This is the theoretical case for Central Bank independence which has a long term vision.

Empirically, economic literature on this subject is not definitely in favour of central bank independence, though the dominant thinking is for independence. Grilli, Masciandaro, and Tabellini in 1991 developed an index for measuring central bank independence. The index mainly tried to measure two factors: political independence and economic independence. These factors comprise the following sub-factors:

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Figure 1: Showing the various factors that comprise political and economic independence of Central Banks.

Mainly, central bank independence has to be thought of in two main areas. Firstly, does the central bank have goal independence? Many central banks are given the mandate of price stability or the dual mandate of growth and price stability by the government. Secondly, does the central bank have operational/instrumental independence? In this kind of independence, the central bank can choose its instruments for achieving its policy goals and the timing of its use.

The strongest evidence for central bank independence is given by a simple regression plotting level of inflation and measures of central bank independence. The figure below shows inflation and central bank independence for industrialized economies using data from 1955 to 1988.

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

Figure 2: Showing the relationship between inflation rates and central bank independence for the period 1955-1988. Source: Alesina and Summers (1993)

More modern studies have also been able to replicate this particular relationship.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Figure 3: Showing the relationship between inflation and central bank independence for 1995-2005.

Finally, studies have also shown that central bank independence is strongly correlated with lower variance in inflation. The Alesina and Summers paper show this graphically for the same period.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Figure 4: Showing the relationship between Central Bank independence and variance in inflation.

Thus, central bank independence results, more often than not, in low and stable inflation rates. Low and stable inflation rates, as economic theory has repeatedly proved, provides a conducive environment for GDP growth.

Thus, to achieve high growth rates, the central bank must be independent and must strive to achieve low and stable inflation.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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The Macroeconomic Case for Central Bank Independence – I

The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run.

In a pioneering paper titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, engineer turned economist E.W Phillips noticed a statistical correlation between two macroeconomic variables that would define economic policies in the decades to come. He noticed an inverse relationship between unemployment and inflation, i.e. when unemployment was low, inflation was high and vice-versa. Graphically, this is a downward sloping curve as shown below.

Figure 1: The original Phillips curve for the period 1948 to 1957, showing the inverse relationship between inflation and unemployment.

Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment.

This particular statistical relationship had huge implications for fiscal and monetary policy. The correlation between the two macro variables was now seen as a trade-off – an economy can lower unemployment if it tolerates a bit of inflation. Noted economists Solow and Samuelson used this relationship to advocate large governmental (deficit) spending and lower interest rates. The rationale behind this was that as long as you can lower unemployment rate, through increased GDP growth, a slightly higher level of inflation can be tolerated. It was believed that the welfare gain through higher growth and lower unemployment would offset the welfare loss due to a higher rate of inflation.

This line of reasoning was employed in the US in the 1960s – the decade of previously unprecedented economic growth – to reduce unemployment to record lows while inflation went up only slightly. Democratic President Lyndon B Johnson initiated “The Great Society”, which involved huge government expenditure to boost growth and lower unemployment. In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits. Notice that the unemployment rate was reduced from 7% in 1961 to less than 4% in 1968, with inflation increasing from about 1% to 4% in the same period.

 

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Then came the great stagflation. The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. Inflation and unemployment both increased simultaneously. This peculiar phenomenon was called as stagflation (a term coined by British Chancellor of the Exchequer, Iain McLeod to denote stagnation plus inflation). The US stagflation is wrongly attributed, even today in most economic textbooks, to the infamous oil price shocks in the early 1970s. However, that is simplistic and flawed reasoning. The real cause of the episode of stagflation in the US is the buildup of inflation momentum. By the time of the OPEC oil shock, inflation in the US had doubled from 3% to 6% due to the expansionary fiscal and monetary policy followed in the 1960s. The high US inflation caused the dollar to depreciate in the world markets and since oil was invoiced in dollars, the OPEC was forced to increase their prices.

The Long Run Phillips Curve

The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve.  The EAPC demonstrated that the Phillips curve tradeoff holds true only in the short run and it turns vertical in the long run. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher. This is shown in the graph below. Taking 1981 as the end period (before Paul Volcker’s war on inflation in the 1980s), it can be seen that unemployment has increased by half a percentage point, while inflation has increased by about 8 percentage points from 1961.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables.

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

Relevance Today:

Due to the inherent nature of democratic cycles, most policy makers in developing countries still try to trade off high GDP growth rate with inflation. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Thus, it is always tempting for policy makers to push through policies that increases GDP growth rate immediately (especially, if the elections are around the corner) and worry about inflation in the next term or leave it as a parting gift for the next government.

India saw incredible growth rate between 2004 and 2009 mainly because of policies (both monetary and fiscal) that pushed the GDP growth rate above its potential GDP (See post on Potential GDP). Expansionary fiscal policy through increased welfare spending (MGNREGA, MSP, etc) along with interest rate cuts by the RBI (through sustained pressure by the Finance Ministry) saw GDP growth rates touch 9% for three years. The long run Phillips curve took effect after 2010 where India underwent a stagflationary period of increased inflation and lower growth.

Much of India’s fiscal policy still aims to take advantage of the short run Phillips curve, despite the knowledge of the consequences it entails. This is precisely the reason why leaving monetary policy in the hands of the government will have disastrous effects. The inherent growth bias in politicians will naturally opt for lower interest rates to push up growth. An independent central bank is not prone to time bound election pressures and will thereby maintain price stability in the long run, which, by itself is conducive to sustainable growth.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

Read Part II Here

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Divergence between Wholesale and Retail Inflation

The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently.

There are two measures of inflation in India: the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). As the name indicates the WPI measures prices at the wholesale level and CPI at the consumer level. Beyond the basics, the number and types of items included in the WPI and CPI basket differ and so does the weights given to these items. Primary articles, consisting of food articles such as cereals, meat, fish and vegetables; and non-food articles such as cotton, cooking oil, jute and minerals, etc are given a weight of about 20% in WPI. The second sub-group is fuel and power, which is given a weightage of 15% and finally manufactured items consists of 65%. In the CPI basket, there are five main sub-categories, which are Food and beverages (35.8%), Fuel and Light (8.4%), Housing (22.5%), Clothing, Bedding, and Footwear (3.9%), and Miscellaneous group which includes services (28%).

Given that the CPI measures retail prices, it is bound to be higher than the WPI, which measures wholesale prices. This has been the case for a long time now and is not a cause for concern as long as both the indices are moving in the same direction. The central bank can gauge the general trend of inflation. However, the latest WPI data available for June was at -2.4% and CPI inflation was at 5.4%, a whopping 7.8% difference. There has been significant divergence between the two indices since November 2014, with the WPI steadily dropping and the CPI inflation crawling upwards, as this graph indicates.

The WPI and CPI have been moving in diametrically opposite directions recently.

The WPI and CPI have been moving in diametrically opposite directions recently.

The exact reasons for such a sharp divergence remain unknown. Mr. Subbarao, former Governor of RBI admitted that “We do not yet have a full understanding of the process by which wholesale price changes are transmitted to retail prices or of the magnitude of the associated pass-through and lags.”

The divergence between the wholesale and retail prices could indicate that there is an increasing inefficiency in the supply chain between the farmers, producers and the end consumer. The middle man might be making gains. Another reason could be that one of the indices is seriously wrong or is not capturing what it should.

Another cause is the structure of the different baskets. As nearly 65% of WPI is made of manufactured goods, reduced global oil and energy prices would have played a big role in lowering costs. Also, there is a general slack in the manufacturing sector in India at present, which is corroborated by low and falling IIP numbers. For the CPI, prices of food, housing and services, the three big components, have not shown any indications of easing.

It is also important to note that WPI index is usually the lead index and CPI lags behind. It takes time for the wholesale prices to pass through to retail. Historical data indicates that CPI usually converges with WPI after a considerable lag.

Regardless of the cause for the divergence, it has serious implications for monetary policy decisions. While the RBI solely focussed on the WPI before the current Governor, Raghuram Rajan took office in 2013, it now focuses unilaterally on the CPI as the leading indicator of inflation in India. Arvind Subramaniam, the Chief Economic Advisor to the PM commented on this, asking the RBI to consider both WPI and CPI while making a decision on interest rates.

Both wholesale prices and consumer prices are important, but to different agents. Consumer behaviour is usually a response to the trajectory of retail inflation but companies decide based on wholesale price movements. The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently and makes it harder to take a decision based on contradicting data.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Repo Rates

by Anupam Manur & Varun Ramachandra

The Repo rate is the interest rate at which the Reserve Bank of India lends to commercial banks.

A cursory glance at the business section of newspapers shows us the concern or elation every time the Reserve Bank of India (RBI) hikes or reduces the Repo rate. Commonly called policy rates outside of India, a change in the repo rate can result in an upswing or downswing of markets.  The obvious questions in the minds of most readers are how does this impact our daily lives and is this the same interest rate that commercial banks levy on us? This article attempts to answer these questions and will hopefully leave the reader with a basic understanding of the significance of repo rates.

The Repo Rate:

The Repo rate (Repo is an acronym for repurchase) is the interest rate at which the RBI (Reserve Bank of India) lends to commercial banks.

The central bank of a country  is usually an independent institution that is set up with the specific intention of maintaining the stability of price and total outputin the economy ( this article will focus on the former). Price stability would result in consistent, and hopefully low, levels of inflation in an economy. Inflation, as Ludvig Von Mises describes it, is an increase in the quantity of money without a corresponding increase in the demand for cash holdings. High inflation leads to people having to spend more money to obtain the same amount of goods and services. The point to note here is that money, like all other commodities, is governed by the principles of demand and supply.

The RBI utilises several mechanisms to maintain price stability but its primary tool is the repo rate.  This  rate, which is charged by the RBI, is different from the interest rates charged by commercial banks.  In a commercial bank, if the interest levied is 8%, a loan of Rs. 50,000 would result in an interest sum of Rs. 4,000 after one year. So, the loaner, usually an individual or business, has to pay back Rs. 54,000 to the bank at the end of the year. The RBI however, does not lend to individuals or businesses, it instead lends to commercial banks in certain circumstances; central banks are usually referred to as the lenders of the last resort. The repo rate is the interest at which the RBI grants short term loans (15 days) to commercial banks facing shortage of funds.

Commercial banks borrow from the RBI on a regular (daily) basis, which explains the high influence of the repo rate. In the week of Mar 15 – Mar 20, 2015, commercial banks in India borrowed Rs.72,672 crores from the RBI at 7.75% rate of interest.

Repo Rate

Fig: Repo rates from March 2004

 Transmission Mechanism:

Hypothetically, if the RBI lowers the repo rate from 8.0% to 7.5%, commercial banks can borrow from the RBI at a cheaper rate. As the RBI has decreased the cost of borrowing for commercial banks, the demand for money will increase; as commercial banks can now borrow more money they can use these funds to lend more money to its customers. In essence, by cutting the repo rate the RBI increases the supply of money (the liquidity) in the market. Commercial banks will now have the maneuvering capability to decrease the lending and deposit rates charged to customers. A cut in the lending rate will induce more people to borrow while a cut in the deposit rate will induce people to save less and spend more. Both these mechanisms result in an increase of the disposable incomes of individuals, which further leads to increased consumer spending.  This sequence of events may not necessarily happen all the time, but a change in the repo rate generally gives the banks an impetus to act in the direction of the rates.

However, it must be kept in mind that a change in the repo rate by the RBI can also impact the exchange rate of the rupee. With all other factors remaining the same, a cut in the repo rate can lead to the depreciation of the rupee and vice versa. A fall in the repo rate can make most rupee denominated financial assets less attractive to investors than foreign currency denominated assets. The rate of return on most financial assets in a country will be tied to the interest rates (government bonds, equity, etc). Thus, when the repo rate decreases, the rate of return to the foreign investors also decline. This will precipitate a decrease in inflow of foreign currency into the economy, thereby reducing the demand for rupees which will cause the rupee to depreciate. The fallout of this is that imports become more expensive and the prices of exports go down.

A change in the repo rate can cause an increase or decrease in the supply of money in the markets, which has profound implications on the lives of people as this directly impacts the price of goods and services that we consume on a daily basis.

Anupam Manur is a Research Associate at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

 

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Look before you repo

Sneha Shankar

The Indian economy needs a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. 

Last Wednesday came as a bit of a surprise to most of us that follow the RBI’s moves. The Raghuram Rajan-led inflation-fighting squad did not increase the repo rate by the 25 basis points it was predicted to. Rajan attributes his move, or a lack thereof, to insufficient data and ‘noise’ in the available set: Given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty.”

The animadversion to this has been plenty with many bringing to question his hardboiled inflation-fighting reputation.  Increasing repo rates would have been the next logically sound move: it would have increased the cost of borrowing for banks, which in turn would have resulted in an increase in interest rates, and thus reduced spending within the economy. With a pause on market consumption, aggregate demand would have reduced to soothe inflationary pressures. While I agree with these folks to a large extent, they have failed to take into account that we aren’t undergoing just inflation; it’s stagflation – a precarious combination of high inflation, high unemployment, and poor growth. By hiking repo rates right now, the cost of debt for businesses would have increased, only exacerbating growth, resulting in an economic zugzwang.

What the Indian economy needs is a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. Maybe the move was a good, calculated one at that.

How does that work?

Let’s take a look at what’s causing the inflation. The high rates (11.24 percent yoy increase in November) have predominantly been attributed to supply shocks in the food and fuel sectors. The food Consumer Price Index (CPI) has been indicating a month on month increase 1.38 percent from October to November, and increase of 2.42 percent from September, and fuel prices reflect similar rises, having grown from 136.1 in September to 137.5 in November.

This food-price driven inflation could, if the RBI is right, subside with the introduction of the recently-harvested kharif crops into the market, but even that might be being a tad quixotic. CPI data over the past few years doesn’t reflect that. The last time we saw a decline post-November in food CPI was November 2011 to February 2012 (a decline from 113.9 in November to 112.4 in December, but an increase then on to 113.4 in February), but even that reduction was not sufficient to bolster the RBI’s current stand.

Also, there hardly seems to be any evidence to indicate a fall in fuel prices. The CPI in the fuel sector indicated an increase from 136.1 in September to 137.5 in November, despite the fall in petrol prices in both September and October.  Also, interestingly enough, Diesel prices have increased by Re.1 (pre-tax) from September to November, and almost all agricultural equipment run on diesel. There is nothing to indicate the extent of impact that this fuel price hike could have had on the aforementioned inflation in the food sector, but one can’t entirely discount it either. Are there other indications that fuel prices will fall in the near future? None, really, but some hopefuls state that with the Rupee having stabilised, fuel inflation should moderate soon.  But then again, they are hopeful about it, and there seems to be little evidence to corroborate that.

Although everything seems to be pointing at a continued inflation, there is a lack of clarity about the possible outcomes. This was probably the ‘noise’ Rajan was talking about. It could either flip either way, and if they do occur, we do not know if one will offset the other.  On a slightly-off note, many Keynesian analysts have repeatedly stated that this is a supply-side related inflation and tightening the monetary policy would not suffice to address it, but might actually worsen the growth rate.

What about ‘growth’?

Wednesday’s lack of a move, gave the equity market, and businesses in general, a lot to rejoice about. It went a little something like this: By not changing the CRR and the repo rates, businesses that were earlier expecting a more expensive cost of borrowing found that it is now cheaper to borrow than anticipated over the past couple of days. This illusion of a cheaper cost of borrowing has greatly improved business sentiment in the economy, causing most to rejoice and calling this Rajan’s “Christmas gift”. In fact, some banks like SBI, with the same psychological thrust, are reducing home loan rates. This indicates that personal borrowing might also increase. With high liquidity, low CRR, and low IBLR (Inter Bank Lending Rate), this retention of status quo has fuelled credit demand.

So not doing anything has actually done something to boost growth.  But the big, fat concern now is that it results in a surge in the aggregate demand of the economy that could aggravate and contribute to the existing inflationary pressures.

But Rajan and co. claim to be at the ready: “The Reserve Bank will be vigilant… If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted.”

So what does this mean?

It’s all a waiting game now. Some of it looks promising: Baig and Das, economists at Deutsche Bank, in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7 percent month on month(mom) on an average in the first fortnight of December).”

If the inflationary pressures are cordoned off on the food front, they could be exacerbated by the increase in aggregate demand. But to control that, there are measures in place with the contractionary fiscal policy and a growing trade deficit. The extent of the effects of each can only be concluded over time. For now let’s safely say that Wednesday’s move was not as bad as the online chatter says, and fervently hope the RBI gets rid of the ‘noise’ in the meantime.

Sneha Shankar is a research associate at the Takshashila Institution

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