RBI Response To Inflation In The Right Direction, MPC Member Ashima Goyal Says In Working Paper

The Reserve Bank of India's policy response to inflation has been in the right direction given that Indian inflation is mainly supply-driven, according to Monetary Policy Committee member Ashima Goyal.

Food inflation shock is the primitive shock that drives inflation, according to a working paper titled ‘What Drives Indian Inflation? Demand Or Supply' —co-authored by Goyal, emeritus professor of economics at Indira Gandhi Institute for Development Research, and Abhishek Kumar, associate fellow at the Centre for Social and Economic Progress.

Inflation, they said, is mainly driven by supply shocks and excessive monetary policy reaction hurts the real economy. “Excess tightening would not improve credibility if excess demand due to supply-side deterioration causes inflation persistence.”

“The recent policy decisions by the RBI have been in the right direction where the bank approached the inflation originating from a food price shock more pragmatically.”

Understanding the drivers of inflation is important for understanding the business cycle. In this paper, Goyal and Kumar have estimated inflation shock and medium-run inflation shock. The inflation shock captures the upward and downward movement in Indian inflation seen in recent years.

The inflation shock causes a 2% quarterly inflation, (or 8% annual inflation), by the second quarter. The impact of inflation shock disappears around the eighth quarter. Thus, the shock causes inflation for up to two years.

The inflation shock explains more than 80% of the forecast error variance in consumer price forecasts between zero and 40 quarters. This shock increases price and decreases output, implying that it is a supply shock. It also increases interest rates and decreases credit and investment.

Inflation shock increases interest rate at impact. The maximum impact is a 0.5-percentage-point increase observed around the fourth quarter and the effect disappears around the eighth quarter. As such, the inflation shock causes a positive movement in interest rates for up to two years.

Inflation shock decreases output. The maximum impact is more than a 0.5% decline in output and occurs slightly late (lagged effect of interest rate tightening). Surprisingly, the effect on output persists at the end of the 40th quarter and seems permanent.

Interest rate response significantly to the shock, the authors said, while the inflation shock decreases credit. The effect on credit persists by the end of the 40th quarter.

Inflation shock decreases investment. The maximum impact is around a 2% decline in investment and occurs around the 10th quarter.

The effect on investment persists by the 20th quarter, that's up to five years. The inflation shock increases government consumption expenditure at impact and the effect disappears by the fourth quarter.

The shock explains 40% of the variance of credit, output, investment and interest rate up to 40 quarters, suggesting that this shock is an important driver of the Indian business cycle.

Inflation and medium-run inflation shocks are supply shocks and there is evidence that monetary policy reacts to these adverse supply shocks which have substantial real effects, the paper argued.

The authors also said inflation originates mainly from supply side but becomes more demand-driven after a year when the effect of interest rate tightening reduces supply more than demand.

Thereafter, they identified food and non-food inflation shocks.

Food inflation shock increases food prices by almost 2%. This is very similar to the rise in overall price due to the inflation shock reported earlier.

Food inflation shock does not affect the non-food price at impact but significantly increases (by 0.25%) non-food price with some delay. This is evidence of a significant pass-through of food inflation into non-food inflation.

This is expected because higher food inflation may lead to increasing costs of industrial inputs such as labour and material. But given the maximum response of non-food prices due to food inflation shock and its share in the overall price index, this means that the inflation shock is still predominantly a food inflation shock. The increase in the interest rate due to the food inflation shock is similar to the increase due to the inflation shock but the response is slightly lower in magnitude.

Credit and investment contracts significantly due to the food inflation shock. Output also contracts due to food inflation shock and the effect is prolonged. Overall, the food inflation shock has similar effects on interest rate, credit, investment, and output as given by the inflation shock.

Non-food inflation shock increases the non-food price by almost 1.5%. Non-food inflation shock increases the food price at impact but the effect turns insignificant soon. Non-food inflation shock does not affect the interest rate, credit, investment, and output in a significant way.

“Therefore, one can say that the responses given by inflation shock are driven by the food inflation shock which further suggests that inflation is mainly supply-driven.”

Also, the contribution of food inflation shock in explaining other variables increases over time whereas the contribution of non-food inflation shock either stagnates or decreases over time. This is expected as the monetary policy reacts significantly to food inflation, the paper said.

Based on the maximum response of non-food inflation due to food inflation shock and the share of non-food in overall prices, the inflation shock is still a predominantly supply shock—originating and operating through food inflation. The central bank may indeed respond to such inflation under an inflation targeting regime but it leads to a permanent effect on output as the range of estimates in this paper indicate.

“A more calibrated and flexible approach is required under the inflation targeting framework.” The recent policy decisions by the RBI have been in the right direction where the bank approached the inflation originating from a food price shock more pragmatically.