A high “statistical base effect” of the last year will soon push India’s inflation—as measured by the Wholesale Price Index (WPI)—into negative territory and is expected to keep WPI inflation negative for a good part of this calendar year. Has inflation been tackled once and for all?
The reply to that is a resounding no. Why? The answer lies in how inflation is defined in the first place. This is where the Austrian school of economic thought (following in the tradition of Carl Menger, Ludwig von Mises and F.A. Hayek) differs from mainstream economists in a big way. The Austrians define inflation as the aggregate expansion of total money and credit. This definition has no mention of purchasing power or prices.
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Mainstream economists define inflation as the rate of increase in the general level of prices of goods and services. According to the Austrian school, inflation occurs when there is excess liquidity than the actual savings in the economy. For the Austrian economists, the rise (fall) in narrowly conceived indexes such as the Consumer Price Index (CPI) and WPI are just symptoms of inflation (deflation) and not the cause. The true cause of inflation is always excess money supply or credit relative to the real pool of savings present in the economy.
Moreover, trying to capture inflation through simple price indices can throw up a completely misleading picture about the financial stability of an economy. For example, if the excess money supply had found its way into stock markets or in the real estate sector, price indices such as CPI and WPI will not reflect such a bubble as asset prices do not form a part of CPI or WPI. Therefore, despite inflationary pressures being present, price indices may reflect a much more benign picture of the economy, leading to a further aggravation of the problem. Readers can refer to a brilliant paper on this issue titled Is price stability enough? by economist William R. White of the Bank for International Settlements.
The future outlook on India’s inflation changes considerably if one defines inflation from the perspective of the Austrian school rather than depend on the mainstream methodology of calculating inflation through price indices. An Austrian economist who considers inflation only as a monetary phenomenon will focus his attention on broad money supply (M3) growth to get a gauge of the true inflation prevailing in the economy. How is the broad money supply growth target determined each year? The M3 growth target is derived by the Reserve Bank of India (RBI) by assuming a certain gross domestic product (GDP) growth and expected inflation for that fiscal year. In simple terms, M3 growth should equal nominal gross domestic growth (GDP) growth (ex ante Real GDP growth plus ex ante inflation) after factoring in the income elasticity of demand for M3 growth (stable for India at 1.4-1.5 according to RBI’s study). For example, if RBI expects the Real GDP to grow at 7% in fiscal 2009 and expects average WPI inflation to be 9.2% for the whole year, then the M3 growth target should be 19% (7X1.4+9.2) for fiscal 2009. Currently, M3 is growing at 18.6%, a tad lower than RBI’s target of 19% for fiscal 2009.
After this calculation, one can try to guess what the broad M3 growth should be for the next year to support a particular GDP growth and inflation rate. For example, to support a 7% Real GDP growth (highly unlikely) and a 4% average WPI inflation for fiscal 2010, an M3 growth of 13.8% would be sufficient. If one calculates the same number with a more realistic Real GDP growth estimate of 5.5% and 4% average WPI inflation, M3 growth that would be required is only 11.7%. This means that in both these scenarios, M3 growth has to fall by at least 5-8% from the current levels in fiscal 2010 for the economy to clear at a new equilibrium level without sparking inflation. In fact, this was the experience in the last economic down cycle when credit and M3 growth fell from a peak of 17-18% in May 2001 to 11-12% by August 2003.
In the current down cycle, however, aggressive monetary and fiscal stimuli have been administered (and more likely to come) since October to prevent the economic growth from free falling. The stimuli have resulted in M3 growth remaining at high levels of 18-19%, while economic growth has continued on its downward trajectory. The government’s huge borrowing programme on account of the various fiscal stimuli in fiscal 2009 and fiscal 2010 has already led to severe strains on bond market yields, hampering the effective transmission of monetary policy measures adopted so far. In order to relieve the strain on bond markets, some market participants are, therefore, suggesting a direct monetization of the fiscal deficit as the last resort over and above the back-door monetization of deficits that is already in vogue in the disguise of open market purchases of government bonds. If this were to happen, the money supply growth would continue to remain high or may even increase as monetizing deficits are same as printing money.
While fiscal and monetary stimuli are unlikely to prop up growth in any significant way in the next couple of years, an elevated M3 growth would mean that monetary inflation would again be a source of concern in 2010, though WPI and CPI indices may continue to remain at subdued levels. Implicit inflation as calculated from M3 growth has been higher than the actual average WPI inflation reported in most years (see table). In this perspective, it would be interesting to see what M3 growth target RBI sets for fiscal 2010 in its annual monetary policy scheduled on 21 April.
Graphics by Ahmed Raza Khan / Mint
Kaushik Das is an economist with Kotak Mahindra Bank. These are his personal views. Comments are welcome at email@example.com