- Paul Cashin, and Rahul Anand
- Published Date:
- February 2016
TAMING INDIAN INFLATION
© 2016 International Monetary Fund
Cover design: IMF Multimedia Services Division
Joint Bank-Fund Library
Cashin, Paul. | Anand, Rahul. | International Monetary Fund.
Taming inflation in India / editors: Paul Cashin, Rahul Anand.
Washington, DC: International Monetary Fund, 2016. | Includes bibliographical references and index.
ISBN 978-1-51354-125-9 (paper)
LCSH: Inflation (Finance) – India. | Food prices – India. | India – Economic conditions – 21st century.
LCC HG1232.5.T345 2016
The views expressed in this book are those of the authors and do not necessarily represent the views of the International Monetary Fund, its Executive Board, or IMF management.
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Table of Contents
Roberto F. Guimarães and Laura Papi
James P. Walsh
Prachi Mishra and Devesh Roy
Rahul Anand, Naresh Kumar, and Volodymyr Tulin
Kamiar Mohaddes and Mehdi Raissi
James P. Walsh and Jiangyan Yu
Sonali Das, Adil Mohommad, and Yasuhisa Ojima
Rahul Anand and Volodymyr Tulin
Paul Cashin and Agustín Roitman
This book is a timely look at an important Indian macroeconomic issue—inflation. High and persistent inflation has been a serious macroeconomic challenge for India, particularly in the past decade. India’s high rates of inflation have been underpinned chiefly by high and persistent rates of food price inflation, which cascade quickly into rural and urban wages and into nonfood inflation. Well-entrenched inflation expectations have also been a key driver of India’s high inflation rates.
Over the past decade India has increasingly opened itself to the global economy and has become one of the world’s fastest-growing economies. As it seeks to sustain rapid growth and improve the welfare of its large and fast-growing population, India also needs to aim for greater price stability.
This book documents and analyzes India’s long-ongoing quest to bring inflation down. It grew out of the IMF staff’s ongoing policy dialogue with the Indian authorities, in particular at the Reserve Bank of India and the Ministry of Finance. The focus of several of the chapters evolved from the exchange of views with officials from these agencies, and with the many Indian academics interested in these issues.
The IMF is contributing to the advancement of the Indian economy through our ongoing policy dialogue, analytical work, and capacity building. I am sure this book will help in this effort and give due recognition to the authorities’ efforts directed at taming inflation to reduce poverty, raise domestic consumption and growth, and improve the welfare of over 1.2 billion Indian citizens.
International Monetary Fund
High and persistent inflation has presented a serious macroeconomic challenge in India in recent years, increasing the country’s domestic and external vulnerabilities. For example, high inflation contributed to an historic widening of the current account deficit, exposing India to global financial market turbulence and slowing growth. As Reserve Bank of India Governor Raghuram Rajan pointed out at the 8th R. N. Kao Memorial Lecture in 2014, “inflation is a destructive disease … we can’t push inflation under the carpet as a central banker. We have to deal with it.”
A number of factors underpin India’s high rates of inflation, including food inflation feeding quickly into wages and core inflation; entrenched inflation expectations; cost-push shocks from binding sector-specific supply constraints (particularly in agriculture, energy, and transportation); pass-through from a weaker rupee; and ongoing energy price increases. This book analyzes various facets of Indian inflation and their implications for the conduct of monetary policy. Indeed, several chapters are devoted to analyzing and managing food inflation, given the very important role of food inflation in driving overall inflation dynamics in India. Building on this analysis of inflation dynamics, several chapters discuss the role of monetary policy in taming inflation, which is important for the country given the economic and social costs of its high and persistent inflation.
Using the Phillips curve framework, Roberto Guimarães and Laura Papi, in Chapter 1, find that inflation in India can be reasonably well modeled with standard Phillips curves, augmented with a measure of relative international commodity prices. They show that India’s inflation dynamics are explained by both backward- and forward-looking inflation components, and that the output gap, though empirically relevant, is not robust across model specifications. Evidence suggests that the effect of the output gap on inflation is larger at higher levels of inflation, but that inflation becomes more inertial at higher levels.
Because food inflation has played a key role in shaping the dynamics of inflation in India, and made monetary management more difficult, the next few chapters delve deeper into analyzing food inflation. It is widely believed that fluctuations in food and energy prices represent supply shocks, and as such are transitory, volatile, and nonmonetary in nature. For these reasons, food prices are generally excluded from the measures of inflation most closely watched by policymakers in advanced economies.
James Walsh, in Chapter 2, focuses on the role of food inflation in lower-income countries and emerging markets, and finds that food price inflation is not only more volatile in these economies, but also higher than nonfood inflation on average. Walsh shows that food inflation is in many cases more persistent than nonfood inflation, and that food price shocks in many countries propagate strongly into nonfood inflation. Under these conditions, a policy focus on measures of core inflation that exclude food prices can misspecify inflation, leading to higher inflationary expectations, a downward bias to forecasts of future inflation, and lags in policy responses. In constructing measures of core inflation, policymakers should therefore not assume that excluding food price inflation will provide a clearer picture of underlying inflation trends than headline inflation.
Chapter 3, by Prachi Mishra and Devesh Roy, examines food inflation in India using a high-frequency, commodity-level data set spanning the past two decades. Documenting stylized facts about the behavior of food inflation, the authors explicitly quantify the contribution of specific commodities to food inflation in India. Their analysis suggests that animal source foods (milk, fish), processed food (sugar, edible oils), fruits and vegetables (for example, onions), and cereals (rice and wheat) have been the primary drivers of food price inflation. Insights from this analysis of overall food inflation, as well as individual case studies, are used to make specific policy recommendations for curbing inflation.
In Chapter 4, Rahul Anand, Naresh Kumar, and Volodymyr Tulin investigate the demand and supply factors behind the contribution of relative food inflation to general inflation. They find that India’s food inflation developments over the past decade appear to have largely reflected demand pressures (driven by strong private consumption growth), which have often outpaced supply of key food commodities. Their analysis suggests that in the absence of a stronger food supply growth response, food inflation may exceed nonfood inflation by by 2½–3 percentage points per year. Given this, the sustainability of a long-term inflation target of 4 percent under India’s recently adopted flexible inflation-targeting framework will depend on enhancing food supply, agricultural market-based pricing, and reducing price distortions. A well-designed cereal buffer stock liquidation policy could also help mitigate food inflation volatility.
The next few chapters explore the costs of inflation in India—on both growth and inclusiveness—and document the spillovers of Indian inflation to the neighboring countries of Nepal and Bhutan. In Chapter 5, Kamiar Mohaddes and Mehdi Raissi examine the long-term relationship between the consumer price index for industrial workers (CPI-IW) inflation and GDP growth in India. Using a sample of 14 Indian states over 1989–2013, the chapter’s findings suggest that, on average, there is a negative long-term relationship between inflation and economic growth. The authors find there is a statistically significant inflation-growth threshold effect in states with persistently elevated consumer price index inflation rates of over 5½ percent. These findings suggest that the Reserve Bank of India needs to balance the short-term growth-inflation trade-off, in light of the long-term negative effects on growth of persistently high inflation.
In Chapter 6, James Walsh and Jiangyan Yu analyze the effects of inflation on income inequality, and find these can be differentiated by the type of inflation. Higher nonfood inflation is strongly associated with greater income inequality, but food inflation has more mixed effects. Across a sample of Indian states, nonfood inflation is associated with worsening income inequality in both urban and rural areas. On the other hand, higher food inflation has an ambiguous relationship with income inequality in urban areas, but is strongly associated with lower income inequality in rural areas.
Sonali Das, Adil Mohammad, and Yasuhisa Ojima, in Chapter 7, explore the spillovers of Indian inflation—particularly food inflation—on Nepal and Bhutan. Inflation dynamics in both countries are closely linked to those in India, given their exchange rate pegs to the Indian rupee. The authors suggest that food inflation in Nepal, a key driver of the country’s headline inflation, is highly correlated with food price changes in India. Similarly, headline inflation in Bhutan over the past three decades shows a tendency to comove with India’s headline CPI inflation rate. Given their exchange rate regimes and close trade ties with India, it is unlikely that inflation will be delinked from India in the near term.
Against a backdrop of the high cost of inflation and spillovers to neighboring countries, Chapters 8 and 9 discuss the role of monetary policy in taming India’s high and persistent inflation. Sonali Das, in Chapter 8, evaluates the effectiveness of the credit channel of monetary policy transmission. Using stepwise estimation of vector error correction models, she finds significant, albeit slow, pass-through of policy rate changes to bank interest rates, and evidence of asymmetric adjustment to monetary policy. Here, bank lending rates adjust more quickly to monetary tightening than to loosening. Moreover, the speed of adjustment of bank deposit and lending rates to changes in the policy rate has increased in recent years.
In Chapter 9, Rahul Anand and Volodymyr Tulin discuss the role of monetary policy in combating food inflation in India, as this has presented challenges for monetary management. It is a widely held view that central banks should only respond to changes in underlying core inflation and to any second-round effects on core inflation of commodity price shocks. This chapter estimates the size of these second-round effects and finds particularly large effects in India. The results also indicate that India’s inflation is highly inertial and persistent. The authors’ analysis suggests that to durably reduce India’s relatively high rates of inflation, the monetary policy stance needs to remain tight for a considerable length of time.
Paul Cashin and Agustín Roitman, in Chapter 10, examine the role of optimal monetary policy in the presence of large and persistent supply shocks. They show that responding to headline inflation is welfare superior to responding to core inflation, and that this often proves to be a more effective response in containing overall inflation, as well as in mitigating consumption and output fluctuations. Moreover, having a clear, easy-to-understand, and transparent rule can help with the formation of accurate and realistic inflation expectations, and serve as an effective nominal anchor in the face of international commodity price fluctuations. Implementing such a rule is also useful to build and enhance the credibility of the monetary authority, and thereby increase the effectiveness of monetary policy in seeking to achieve and maintain price stability.