The roots of inflation in India

As Raghuram Rajan steps down as governor of the Reserve Bank of India (RBI), it is widely agreed that the adoption of an inflation-targeting monetary policy regime is one of his signal accomplishments. For instance, an unsigned leader in Mint argued that this was “undoubtedly Rajan’s most defining contribution to policymaking as governor”.

Controversies around whether inflation targeting makes sense as a policy choice, for India in particular, are not new. I sifted some of the issues in a recent Mint column.

Briefly, proponents argue that as inflation targeting is the gold standard for advanced economies, it makes sense that India, too, should adopt it.

Critics point to the failure of inflation-targeting central banks to pick up on, and defuse, destabilizing bubbles in asset prices that helped precipitate the 2008 global financial crisis, arguing that this calls into question the bona fides of such a regime. This debate is still unsettled.

Logically, however, any such debate should be grounded on an understanding of what actually causes inflation in the first place, if it is to reach any sort of viable conclusions in the specific context of a given economy, India in this case.

A very recent research paper released by the International Monetary Fund is only the newest in a spate of research trying to understand the roots of inflation, and, in particular inflation dynamics, in India.

Authored by economists Sajjid Chinoy of JP Morgan and Pankaj Kumar and Prachi Mishra of the RBI, the paper attempts to understand the sharp disinflation which set in during the past three years following a period of high and persistent inflation from 2006 to 2013.

As the authors note, headline inflation in the consumer price index (CPI) averaged more than 9% between 2006 and 2013. But, after peaking at 12.1% year-on-year in November 2013, CPI inflation plunged all the way to 4.3% by December 2014, just over a year later. Since then, it has accelerated back to the 5% range, but remains well below what is was the during the period of high and persistent inflation from 2006 to 2013.

The obvious question is, what caused the collapse in inflation after November 2013? And, as a follow-up, based on the answer to the first question, is the current period of low inflation sustainable or merely a transitory phase back towards higher inflation?

As the authors themselves aver, this is a knotty problem. The disinflation starting in late 2013 occurred at a time of many changes in both the global and the Indian economy and polity, making it difficult to disentangle and assign relative importance to the various possible causes.

Among many others, this period witnessed a sharp fall in global oil, commodity and food prices; a new Indian government working on, among other things, easing bottlenecks in the food supply chain; government restraint on minimum support prices (MSPs) in agriculture; and, notably, the announcement of the new inflation-targeting regime itself.

The researchers eschew a conventional multi-equation framework in favour of a simple, singe-equation statistical model to find that of the 3.3 percentage point disinflation which occurred between fiscal years 2013-14 and 2014-15, fully 46% is attributable to “lagged inflation”.

In statistical terms, lags of inflation from previous quarters capture the fact that inflation expectations tend to be “adaptive” or backward-looking in India, as well as capturing the persistence in inflation dynamics in India. This latter fact is attributable to the way in which wages and MSPs themselves are set, which tends to also be backward-looking rather than based on expected future inflation.

Of what remains, 21% of the disinflation was found to be due to the discretionary component of MSPs: basically, that the setting of MSPs was less inflationary over the 2013-14 to 2014-15 period than before. Perhaps surprisingly, the role played by factors often featured in journalistic and non-technical accounts of falling inflation seemed to play a very minor role, at best.

Thus, the much-touted falling global crude oil prices accounted for a scant 2% of the total disinflation. Likewise, the much-discussed greater stability in the exchange rate accounted for only 11% of the total disinflation.

What is perhaps most interesting is that the second largest component amongst the explanatory variables, after lagged inflation, is a “dummy” variable (that is, a variable which takes the value of 1 when a given factor is present and 0 when it is absent) capturing the new monetary policy regime. This factor accounts for fully 33%, or just under a third, of the total disinflation.

This potentially important finding must be interpreted with caution, as the authors themselves note. The statistical analysis employs a dummy variable which takes on a value of 1 during the period from the first quarter of 2014 to the first quarter of 2015. This time period coincides with the introduction of the new monetary policy regime, which is this reason why this component is identified by the study as due to the new regime itself.

But, in a broader sense, this dummy variable could capture a range of factors which anchor expectations of future inflation, apart from the new monetary policy regime. Thus, for instance, if the public expected future oil and commodity prices to continue to be low or dropping, and if they believed that this would mean inflation itself would be lower in the future, this belief, quite unconnected to the new monetary policy regime, would also be soaked up by the dummy variable.

The basic conclusion of the research paper is, as the authors suggest, to debunk the narrative that the sharp disinflation which occurred in India starting in late 2013 was due principally thanks to “good luck”, such as dramatic drops in global oil and commodity prices and other popular explanations.

Their bottom-line conclusion is that “exogenous shocks to inflation... were perpetuated through backward looking expectations and domestic institutional structures that amplified the influence of the original shocks”. This is not a conclusion that is easily amenable to a quick sound bite, unlike the good luck story, so perhaps it has not yet filtered into the wider discourse.

The Chinoy-Kumar-Mishra paper is a useful addition to what, as I noted earlier, is a large body of research going back many years trying to understand the causes of inflation in India. (A good starting point is a 2015 research paper by economists Laurence Ball of Johns Hopkins University, Anusha Chari of the University of North Carolina, Chapel Hill, and Prachi Mishra of the RBI.)

An important milestone in this earlier literature worth delving into briefly is an influential 2012 research paper by the late Gangadhar Darbha and economist Urjit Patel. The latter author will be well known to Indian readers as the RBI governor-designate, and, notably, the chairperson of an important RBI committee commissioned by governor Rajan, which submitted its report in January 2014.

The Patel committee was tasked with proposing ways to “revise and strengthen” India’s monetary policy framework, and the final report which came out of its deliberations recommended that India adopt inflation targeting, which indeed was subsequently adopted and enshrined as the new policy after a vigorous public debate.

Without getting into the technical details of the Darbha-Patel paper, which deploys finance-theoretic concepts and statistical methods somewhat different from what would be typical in macroeconomics, it is noteworthy that the unstated subtext appears to be to provide a scientific foundation for the theory and practice of inflation targeting.

Readers will note that the paper begins with a sharp critique of a statement by the then RBI governor, D. Subbarao, which appears to suggest that the complexities of the Indian situation make it difficult if not almost impossible for the RBI to single-mindedly pursue a CPI inflation target. The authors not only disagree with this proposition, they go so far as to call Subbarao’s statement “nihilistic” and lacking “even a hint of scientific thoroughness”!

The conclusions of the Darbha-Patel paper, in the same spirit, suggest that their research debunks the notion that complexity and idiosyncratic factors make it impossible for the RBI to meaningfully target an inflation rate. Their basic message is that economy-wide factors have driven inflation dynamics in recent years in India, rather than the conventional narrative that they are driven by, say, food and fuel prices.

The implied conclusion, but not stated explicitly in the paper, is that shifting to a policy of inflation targeting might make sense.

It is rare for an economist to write an academic paper on a topic, to follow it up a few years later with an official report proposing a particular change in policy, and then also still be a key official in that sphere a few year later when the proposal that he championed actually becomes policy.

Yet, this is the case with Urjit Patel and inflation targeting. The fairy-tale ending is that Patel is now becoming the RBI governor, and thus could cement his reputation as an inflation-targeting economist, both in theory and in practice.

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