Monetary policy in India: A shocking exposé?

Just finished looking at a new paper by Rudrani Bhattacharya, Ila Patnaik and Ajay Shah, titled “Early warnings of inflation in India.”

This was a real eye-opener. The issue tackled in the paper is central to the conduct of monetary policy: how do you measure current inflation, and identify inflation pressures quickly? The headline figure in India, which seems to dominate policy formulation, is the year-on-year change in the Wholesale Price Index (WPI). The WPI is reported weekly, but the inflation figures are always calculated for twelve months, i.e., year-on-year. The authors here do something pretty straightforward. They construct a monthly point-to-point inflation measure. Since they are going to this frequency, some seasonal adjustment is needed.

Here is the shocker from their results. It suggests that the RBI pursues an expansionary policy when it should be tightening, and tightens when inflation pressures have subsided, all because it uses the wrong measure of inflation, when a simple alternative is available.

I just quote from the paper, regarding the high inflation episode of 2007:

“Going by the year-on-year series, the high inflation episode erupted in January 2007 and ended in April 2007. The POP SA data, however, shows a very different picture. It shows that the high inflation episode began in May 2006 : an early warning of 8 months. POP SA inflation was high in the period from

May 2006 till October 2006: over this period, inflation averaged 7.81%. The inflationary pressures subsided by October 2006, before the high inflation episode had even showed up in the year-on-year data. To the extent that policy responses took place after October 2006, they were possibly in the wrong direction. In the critical period from May 2006 to October 2006, when there was high inflation, monetary policy was expansionary. Monetary policy tightening is visible much later. The real rate went up from -0.55% in September 2006 to 3.35% in June 2007. Inflation had subsided before the tightening began.”

There’s some analysis of the current, ongoing inflation episode, which I will leave to readers to pursue from the paper directly (don’t want to take away their punchline). By the way, Joshua Felman of the IMF had highlighted this issue of early warnings from monthly measures earlier this year, and I had recently used his analysis to argue against further RBI tightening.