Inflation Targeting – Has Monetary Policy Failed to Deliver??

The sharp increase in inflation (CPI) to 7.35% for Dec’19 has put a question mark on whether inflation targeting (IT) based monetary policy really works? While the question may be pertinent, it would actually be ridiculous to blame monetary policy for this spurt. More importantly, it is essential to deliberate on the proper indicator of inflation which monetary policy can influence. Here is a look at the dynamics of inflation and how monetary policy works.

First a look at the inflation numbers. CPI inflation rose to 7.3%, up from 5.5% in Nov’19 and 4% in Sept’19. Within this, inflation for vegetables rose by 60% driven by abnormally high inflation of over 450% for onion. Excluding vegetables, CPI would be closer to 4%. While CPI has risen so sharply, WPI stood at 2.6%. Further, WPI inflation for manufactured products (which excludes food & fuel) has recorded a decline of 0.25%.

First is brief attempt to understand what drives inflation. Inflation is either cost push which means prices of inputs are rising faster or demand pull which means output is not sufficient to meet all the needs. These are natural phenomenon and can be impacted by appropriate monetary policy, essentially raising interest rate prevailing in the economy. This reduces consumption by making loan-based purchases costly and by increasing the propensity to save by virtue of higher interest rate. This brings greater alignment between production and consumption and cools the economy.

Another dimension of this debate is core inflation vs inflation in fuel & food. While monetary policy work reasonably well in cases of core inflation, they are not so effective in case of food & fuel. This is so because food demand doesn’t decline much even in case of price rise (low elasticity). On the contrary, it leaves households with lower disposable income and reduces demand for other segments. Monetary tightening in such a case would further affect the demand for other sectors and throttle growth. The reason in case of fuel is that it is a global product, not influenced by the monetary policy of any nation. Further, it is not exactly a market-driven commodity but prices are managed by the oil cartel, OPEC. So, even if the demand is low, the cartel may cut production and thereby, keep the prices up. Monetary policy in case of fuel price rise does have an impact, but on what is called “second order inflation”. Monetary tightening in this case impacts the demand for products & services which consume high amount of oil and helps bring down its demand. However, it also affects other segments and therefore, comes at a price of lower growth. These abnormalities are understood very well and central banks across the world monitor core inflation, excluding food and fuel, and adjust monetary policy accordingly.

However, there is yet another way prices may rise which is most notorious and cause of most of abnormal price rises. This is inflation due to disruption in supply. Current spike in inflation is a result of rise in prices of onion, a result of short supply. No amount of monetary tightening could have regulated the demand of onion anticipating an impending shortage! The supply side issues require careful monitoring and advance planning. For instance, if the concerned ministries had looked at past trends/ projected production and ordered imports before the crisis broke out, things would have been entirely different. It would be pertinent to mention another recent event which could be a source of significant inflation a few months from now. India has stopped imports of edible oil from Malaysia recently for certain reasons. If this is not followed up by an alternate source of import, it is certain to cause shortage and a sharp price rise once the existing stock runs out.

A funny argument being made is that lowering of interest rate by 135 basis point over last one year has led to this jump in inflation. So, has lowering of the interest rate increased money supply so much so, that people have increased their intake of onions. Nothing else but onions, so much so that its price has risen by 450%! For sure, this can have an impact because there is definitely an excess of liquidity at the moment. Banks parked nearly Rs 2.4 lakh crore with RBI during Nov’19 (up from Rs 2 lakh crore in Oct’19) as there are no takers. Only when banks manage to pump this money into the economy, the risk of inflation would become a reality.

So, where does this leave us? As mentioned earlier, monetary policy for inflation targeting is not an ineffective tool but needs to be applied carefully. It requires alignment of monetary policy with domestic production capacity and its utilization. For instance, capacity utilization (CU) of domestic manufacturing capacity was only 69% as per Dec’19 policy. And a strong manifestation of this is inflation of -0.25% in WPI (manufacturing products). A demand-pull inflation would require CU to cross at least 80% when monetary tightening can impact the demand.

So, what is needed is change in the benchmark to WPI (core). After all, you can’t reach your destination if the compass is reading North as West!

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9 thoughts on “Inflation Targeting – Has Monetary Policy Failed to Deliver??”

  1. What do you think why CPI based Monetary policy is in place and why RBI reluctant to change it to WPI based?

    P.s. Great article, really helped me in understanding inflation for GP/PI process of IIMs.

    1. The benchmark is set by central government, not RBI. So, it can’t change it. That has been taken as basis because it is CPI which affects the common man most. While the logic is fine, linking monetary policy to that doesn’t really serve the purpose.
      And than for the appreciation. Would be nice if you could share this among your friends too.

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