Despite the Reserve Bank of India (RBI) having hiked rates by 5.25 percentage points in the 18 months till October 2011, inflation as measured by the Wholesale Price Index (WPI) remains at the 7%-plus level. Does that mean monetary policy is ineffective?
Two RBI economists, Muneesh Kapur and Harendra Behera, seek to provide some answers in their paper—Monetary Transmission Mechanism in India: A Quarterly Model.
Shorn of all the econometric wizardry, their conclusion: If RBI hikes the nominal effective policy rate by 1 percentage point in one quarter, the maximum impact on non-agricultural growth would be 40 basis points (bps) reduction after two quarters. Similarly, non-food manufactured products inflation, or core inflation, would be reduced by 25 bps after five quarters. One basis point is 0.01%. Hence, they say that while monetary policy is effective, the “impact of monetary policy actions on inflation is modest and subject to lags”.
Indeed, as this column has pointed out earlier, core inflation has moderated and that means monetary policy has had an impact. Yet, headline inflation has remained high.
The report says the persistent level of high inflation “could be attributed to the structural component of food inflation as well as the surge in international commodity prices beginning the second half of 2010 and continuing into the first half of 2011.”
As Sonal Varma, executive director and India economist at Nomura Financial Advisory and Securities (India) Pvt. Ltd points out, “Food is such a big portion of the Indian consumer basket, and it influences inflation expectation.”
The economists have gone on to quantify the impact of a host of other factors which affect food prices and inflation. Like the monsoon, for example. If the rain in July falls short by 10%, headline inflation shoots up by 60 bps with a lag of three quarters. The long-run impact turns out to be 1.2 percentage points, the study says. The effects of a hike in minimum support prices (MSP) are even more deleterious. A 10 percentage points rise in MSP inflation increases headline WPI inflation by 1 percentage point with lag of a quarter, and the long-run impact is 2 percentage points, the study says.
Another interesting point the study makes is that non-fuel commodity prices have a more immediate impact on inflation than fuel prices. It proves that if non-fuel commodity prices rise 10%, then headline inflation (measured by WPI) increases by 90 bps in that very quarter. Over the long run, output prices can increase by as much as 1.8 percentage points.
The report says, “Oil prices have a muted impact on both growth and inflation, which is a reflection of the delayed and incomplete pass-through of international crude oil prices to domestic prices.”
But as Saugata Bhattacharya, chief economist at Axis Bank Ltd, points out, “One must look at the impact of oil prices holistically. It’s not just about controlled products, but also the freed products such as ATF (aviation turbine fuel), lubricants, fuel oils, and the whole spectrum like of hydrocarbon refinery products such as petrochemicals, synthetic textiles, plastics, etc. These have a ripple effect on consumer discretionary demand.”
In short, the paper makes the point RBI made in its last credit policy—that monetary policy has a limited impact and the government must do its bit.