Surjit Bhalla offers another attack on those who think India’s monetary authorities should increase interest rates. In the Business Standard, he offers these observations:
“Some facts related to overheating … For the twenty-three year period 1980-2002 the Indian economy grew at an average rate of 5.6 percent per annum. Post 2002, now for some six years, GDP growth has taken a step jump towards 8.5 percent. Is this 3 percentage point increase a sign of overheating? Not if accompanied by increased savings and investment; yes, if propelled by unsustainable borrowing. On this simple rule, there is no evidence of overheating as both saving and investment rates have increased by 10 percentage points each – from an average around 23-24 percent to an average of 33-34 percent. Accompanying the surge in growth, has been an equally surprising increase in employment growth from 1.8 to 2.8 percent per annum. Assuming no increase in productivity growth (an unreasonable but conservative assumption), the increase in growth rates of capital and labor would yield a potential GDP growth of an extra 3 percent per annum. Which means a growth rate of 8.6 percent per annum – the actual growth rate during the last six years (including an estimate of 8 percent in 2008/9) was 8.5 percent!
“So no evidence of overheating in the last six years; yet the discussion by policy makers and investment bankers has been consistently that the acceleration in GDP growth has been a consequence of overheating; hence, the need, nay dire necessity, of controlling the side-effects of this heated growth, namely inflation. The GDP data just released indicates a yoy inflation figure (GDP deflator) of 7.6 percent compared to 6.1 percent in the same period last year. Is this a sign of overheating or much more a sign of imported inflation?”
Bhalla uses the above GDP deflator inflation rate to calculate the real interest rate at 1.4%. This reminded me of my microeconomic theory lessons, so I went back to those basics (from Wikipedia):
“The Laspeyres index systematically overstates inflation, while the Paasche index understates it, because the indices do not account for the fact that consumers typically react to price changes by changing the quantities that they buy. For example, if prices go up for good c, then ceteris paribus, quantities of that good should go down.”
The WPI is a Laspeyres index, while the GDP deflator is a Paasche index. Typically, there would not be too much difference between the GDP deflator and a broad-based CPI or PPI – the WPI is a PPI, but it is not very broad-based. Figure 4.8 in the latest Economic Survey of India, Chapter 4, shows the divergence between the WPI and the GDP consumption deflator – the latter rising much less rapidly. So maybe Bhalla’s measure of inflation is too low. (Looking at changes might be helpful – whatever measure is being used, one could assess whether policy is getting tighter or looser.)
In any case, there are two issues that seem to be plaguing monetary policymaking in India, and analysis of the policies in practice – what is the right measure of inflation, and what is the right estimate of potential output growth? It’s amazing that we don’t have good answers to these questions. They seem to matter enormously for determining and assessing monetary policy.
Even the U.S. is not immune to these problems. A nice paper by Adriana Z. Fernandez and Alex Nikolsko-Rzhevskyy looks at measurement alternatives and theoretical variations in the context of the Taylor rule. They assess which measures and theoretical frameworks best fit actual Fed behavior. This doesn’t answer the question, though, as to which measures and formulations are the best ones to use. As far as I can tell, this can’t be determined from theory, because the underlying theory doesn’t work at the level of detail required to distinguish between different inflation indices, or measures of potential output.