Output and WPI inflation respond along expected lines to rate hikes or cuts. But CPI inflation has been on the rise since 2001, irrespective of the monetary policy. This suggests that CPI inflation is more amenable to a supply-side response.

Economic activity generally follows a cycle — increased activity in terms of output and employment, followed by decreased activity. Countercyclical policies act to promote or support growth and employment when the activity is at a low ebb and vice versa. The objective is to achieve balanced and sustained economic activity over time, preventing adverse features like high inflation, and fiscal and current account deficits. Therefore, policies also follow a cycle, a tightening phase followed by an easing phase.

In India, the current operating procedures of monetary policy using the three major instruments of policy, namely, repo rate, reverse repo rate and the cash reserve ratio, were initiated since early 2001.

It will be interesting to see how the policy cycles have behaved since then. If we consider increases in one or more rates of the above three major instruments as a tightening phase and decreases in rates as an easing phase, since April 2001, the periods fall into four phases, two phases each of easing and tightening.

EASING AND TIGHTENING PHASES

The first period — Phase I runs from April 2001 to August 2004, an easing phase; Phase II from September 2004 to September 2008, a tightening phase; Phase III from October 2008 to January 2010, an easing phase; and the Phase IV from February 2010 till date which is a tightening phase. As monetary policy aims at maintaining price stability and supporting growth, an easing phase represents larger emphasis on growth and a tightening phase represents greater focus on containing inflation. The intensity of easing or tightening can be gauged by the extent of the increase in rates in a given cycle, as also from the duration of the cycle (see Graph). In phase I, CRR was reduced from 8 per cent to 4.5 per cent, the repo rate from 8.75 per cent to 6.0 per cent, and the reverse repo rate from 6.75 per cent to 4.50 per cent. For the sake of brevity, if we combine the rate changes into a single figure, it is revealed that the combined decrease in rates was 850 basis points in Phase I.

On a similar basis, Phase II witnessed a combined increase of 900 basis points, matching the first phase. Phase III coinciding with the crisis resolution phase, saw a combined decrease of as much as 1100 basis points, all rates touching their historical lows. In phase IV, since February 2010, a continuing tightening phase, the combined increase has so far been 450 basis points.

What about the duration of the cycles? Phase I lasted for 41 months, II for 49 months. The easing phase III lasted only for 17 months, but that is because the recovery from the impact of the global crisis was faster, and inflationary pressures surfaced quickly.

Based on the earlier evidence, it seems that the current phase of tightening may last for at least another year. But it may go on for longer, depending upon the vulnerability of Indian economy to domestic and global destabilising factors.

The current phase has the added risks of high inflation, widening current account deficit and fiscal deficit. Any extraordinarily accommodative monetary policy, supportive of the growth momentum may land up in very high inflation with unsustainable external sector balances.

OUTPUT, INFLATION RESPONSES

A surprising result is that no particular relationship could be established between the policy rates, money supply and inflation based on consumer price index (CPI). The average monthly year-on-year CPI inflation seemed to have accelerated in a secular fashion from 3.9 per cent in phase I to 5.9 per cent in phase II and to 11 per cent and 12 per cent in subsequent phases (see Table). Likewise, M3 growth showed no particular relationship.

The output response as also the response of inflation based on wholesale price index (WPI), seemed to have performed as expected to easing and tightening cycles, but with a lag. The easing first phase caused the quarterly average year-on-year growth rate to pick up significantly from 4.9 per cent to 9.0 per cent in the second phase; the tightening during the second phase had caused the average rate of growth to decline to 7.6 per cent in the third phase; and the easing in third phase has contributed to the higher growth rate in phase IV at about 9.0 per cent till date. Similarly, the easing phase I pushed the WPI inflation rate to 5.8 per cent in phase II from 4.4 per cent, but the tightening phase in phase II was followed by low WPI inflation of 3.8 per cent. The easing phase of III has now been followed by an average WPI inflation of 9.7 per cent, thus far in the still running in phase IV.

POLICY IMPLICATION

Though these inferences are very crude and subject to more rigorous tests, one can broadly conclude that while monetary easing and tightening seem to have impacted growth and WPI inflation with a lag, any containment of CPI inflation, which is more amenable to supply and external shocks, would require enduring supply responses of wage goods and improvements in distribution.

The forthcoming Budget should pay special attention to this aspect, more than anything else.

(This article was published on February 4, 2011)
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