Inflation: high and volatile

Inflation: high and volatile

Inflation has been on a roller-coaster ride over the past two years: soaring to double digits in the middle of 2008, then slipping into negative territory in the middle of this year, and threatening to push towards double digits once again in the middle of 2010.

A lot’s been said and written about high inflation but there hasn’t been enough attention paid to inflation volatility, even though it has a significant impact on the way in which people make economic decisions. Consider a company that has seen the prices of inputs and finished products bounce around in the past two years. Planning production and investment is a tough job under such circumstances, as many Indian companies have found out over this period.

A recent study by the EPW Research Foundation puts some hard numbers on the issue of inflation volatility. The researchers have divided India’s recent inflation experience into three periods: 1995-96 to 2000-01, 2002-03 to 2005-06 and 2006-07 to October in the current fiscal year.

The standard deviation of the Wholesale Price Index—a common measure of volatility—has doubled between the second and third periods, from 1.7 to 3.4, even though average inflation in the two periods is more or less similar. This means that though the broad inflation trend is similar, the movement around this trend is far more violent in the past three fiscal years.

Economic research shows that high inflation volatility imposes significant costs on an economy because the future inflation rate is that much less predictable. It tends to increase risk premiums and leads to higher costs of hedging against inflation. There is also ample research to show that high inflation volatility affects economic growth in a world of nominal contracts, even if average inflation over a multi-year period is relatively stable.

One explanation for high inflation volatility in India is the high weightage given to volatile food and fuel prices in the standard inflation indices. The other is that inflation volatility is the result of the overuse of discretionary fiscal policy whose effects have to be curbed by long-term monetary policy. There are no clear answers, but this is an issue that Indian policymakers should focus on.

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