If we set aside the WPI and IIP figures for their volatility and look at the GDP deflator to examine price-output dynamics, it is clear that tight monetary policy has not worked.

The Reserve Bank of India announces its mid-quarter review of monetary policy today, shortly after the release of the latest key indicators for output and price respectively — the index of industrial production and wholesale price index.

These numbers play a major role in determining the course of monetary policy. And that can be a problem, when the monthly data is subject to considerable volatility, as has been the case in recent times. Therefore, the GDP deflator, based on quarterly GDP figures, may provide a clearer idea of the impact of monetary policy.

Inflation trends

The inflation rate at 7.2 per cent for November is below analysts’ expectations, besides also being lower than 7.5 per cent recorded in October 2012.

The fall in the inflation rate in November is essentially seen in the manufactured and fuel products to 5.4 per cent and 10 per cent respectively, from 5.9 per cent and 11.7 per cent respectively in October.

Inflation in primary articles has seen an uptick from 8.2 per cent in October to 9.4 per cent in November, guided primarily by cereals, fruits and vegetables and oilseeds.

The positive takeaway from the WPI data is the decline in core inflation to 4.5 per cent. Such low core inflation numbers were recorded way back in the first half of 2010, when the policy tightening had just begun.

Core inflation broadly indicates demand pressure. Now that core inflation has softened, it should give the RBI the comfort to reduce policy rates sooner than later.

This is because the demand pressure which the monetary policy can tackle seems to have moderated to the desired levels.

Overall, the WPI inflation rate signifies continuing price pressure, but of lesser intensity than before.

Base effect in Output

IIP growth rate for October reflected a spurt in output. There is a view among some analysts that guided by the buoyant IIP reading for October, the RBI may prefer to delay the monetary easing process. This reasoning amounts to a wrong assessment of macroeconomic conditions.

The IIP data needs to be interpreted with a number of caveats. IIP growth in October 2011 was minus 5.1 per cent. Thus, the growth in IIP measured on a Y-o-Y basis at 8.2 per cent in October could be because of the low base.

Besides the base effect, the IIP data has been marred with a lot of volatility. The volatility is more pronounced in the capital goods segment.

Many Revisions

Anchoring monetary policy to evolving growth and inflation numbers becomes difficult because of two reasons.

First, the information comes with a time lag. For instance, while formulating policy in December, the RBI has to make do with the provisional output figure for October and provisional price figures for November.

Second, the provisional numbers themselves undergo sharp revision when the revised data is published with a further lag of one or two months.

Over the last year, the revised inflation numbers were higher than the provisional estimates in all the months between during October 2011 and September 2012, except for March 2012. As far as IIP growth numbers are concerned, the variation is in both directions.

The revised estimates were higher than the original for six months during October-December 2011 and again in February, March and May 2012, but lower than the original in the remaining months. The IIP numbers have been revised downwards continuously for the past three months.

With such variations (see table), policy formulation can be reduced to shooting in the dark.

Noise and Signal

The large volatility in macroeconomic indicators amounts to ‘noise’, which can blur the signals emanating from them. Policy should be guided by macroeconomic signals rather than noise.

The noise element in IIP data has increased in the past one year. What should be the course of monetary policy in such circumstances?

An alternative is to look at the performance of GDP and GDP deflator, the most comprehensive indicator of inflation, using the quarterly GDP figures.

GDP growth and inflation averaged 5.4 per cent and 7.3 per cent, respectively, in the last three quarters, compared with a growth of 6.9 per cent and inflation of 8.7 per cent in the preceding three quarters. Pursuing too tight a monetary policy has choked growth without the desired softening of inflation.

The correlation between GDP growth rate and the inflation rate in India over the last four decades is negative and statistically significant. While the correlation suggests a negative association between growth and inflation, it does not throw light on the direction of causality.

Other statistical measures suggest that growth has a large predictive power for inflation, rather than vice-versa. Higher growth is indicative of a better supply response, and hence has a sobering impact on inflation.

The Government has shown its commitment to growth-supporting polices in the last three months.

The RBI should complement the Government’s efforts by easing policy rates.

Given the lags in monetary transmission, it is better the RBI adopts the easing mode sooner rather than later.

(The author is Associate Dean, Xavier Institute of Management Bhubaneswar. The views are personal.)

(This article was published on December 17, 2012)
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