Sudden Rise of the Floaters

by Rajeswari Sengupta and Harsh Vardhan.

The first two months of 2021-22 have witnessed a remarkable new trend in the corporate bond market—a sudden rise in the issuance of floating rate bonds or “floaters” and the use of the 91-day treasury bill yield as the reference rate in these bonds, instead of the yields on dated government securities (G-Secs).

We conjecture that one possible reason behind this new development could be an increase in the perception of interest risk on the part of the bond market participants. This in turn may have been a result of the active yield curve management undertaken by the Reserve Bank of India (RBI). If indeed dated government bonds such as the 10-year G-Secs have lost relevance as benchmark securities then this can lead to serious mispricing of risk in the economy, an unintended consequence of the RBI’s bond market intervention.

An interesting development in the bond market

Over the three-month period from April to June 2021, about 7 percent of the total corporate bond issuance of Rs 1.02 trillion consisted of floating rate bonds. While this percentage looks small, it is important to keep in mind that for the previous ten years or more, the share of floating rate bonds in the total issuance of corporate bonds has been less than 1 percent.

It is also important to note that the firms issuing these bonds and the investors investing in them are not a new class of issuers and investors. They are the same issuers and investors who were issuing and buying fixed-rate bonds until recently. In particular, 100 percent of the floating rate bond issuers now are non-banking finance companies (NBFCs) who were earlier issuing fixed rate bonds, and the investors are the same mutual funds and banks who were investing in fixed rate bonds earlier. This could imply that their behaviour has now changed due to external developments. It is as if the bond issuers and investors have suddenly developed a taste for floaters.

Corporate bonds are typically issued with a maturity of more than one year, along with a coupon, which is the rate of interest to be paid on the bond. Most bonds have a ‘fixed’ coupon—the rate of interest on the bond is decided at the time of issuance of the bond and remains fixed over the life of the bond.

This rate is a function of two factors – (i) the prevailing risk-free interest rate for the maturity matching that of the bond, and (ii) the credit risk spread that is added to compensate the investors for the default risk associated with the issuer.

The risk-free reference rate is ideally the interest rate on the government security of similar maturity. The credit spread is the function of the credit rating of the issuer. For example, if a AAA-rated issuer wants to issue a 5-year maturity corporate bond, then the risk-free reference rate will be the rate for a 5-year government security (let’s say 5.7 percent). If the credit spread of the AAA-rated issuer is an additional 100 basis points (1 percent), then the bond will be issued with a fixed coupon of roughly 6.7 percent. Note that this rate will apply to all the future interest payments by the issuer until the bond matures even if the underlying risk-free rate changes. This means that the investor in this bond is taking the interest rate risk. The secondary market price of these bonds reacts to changes in the underlying interest rates – the bond prices fall if the risk-free interest rate increases and bond prices go up if the risk-free rate decreases.

In the case of a floating rate bond, the main components of determining the coupon remain the same—a reference rate and a credit risk premium. The crucial difference is that the reference rate is no longer fixed but changes over time. Hence, these bonds are referred to as ‘floating’. The coupon on these bonds clearly specifies the reference-floating rate.

If the bond in the example cited above were a floating rate bond, then the coupon on it will not be a fixed rate of 6.7 percent. Instead, it will be the rate on 5-year government security at the time of interest payment plus 1 percent. In other words, for a floating bond, the applicable interest is computed at the time of payment of interest. If the 5-year government security rate moves up by 0.5 percent in a year then the interest rate payable will become 7.2 percent. The investor in such a bond is more protected from interest rate risk and the prices of these bonds in the secondary market fluctuate much less with movements in interest rates.

In the last two months, floating rate bonds worth Rs 70 billion have been issued in the corporate bond market, almost entirely by private companies. Overall, bonds worth Rs 793 billion have been issued by the private sector including NBFCs. The floating rate bond issues in these two months thus represent around 10 percent of private sector bond issuance.

An interesting feature of these floaters issued in the last two months is that all of them have used the yield on 91-day treasury bills (T Bills) as the reference rate. Notwithstanding the fact that these corporate bonds have maturities ranging from 2 to 4 years, yields on dated government securities (i.e., G-Secs with maturity of more than 1 year) have not been used as a reference.

What might explain this sudden preference on the part of the issuers and investors for these floating bonds?

What might be going on?

One possibility could be a heightened perception of interest rate risk. Bond investors might be harbouring the belief that the interest rates on dated G-Secs are unlikely to remain at their current levels. As discussed earlier, issuing floating rate bonds is one way to mitigate interest rate risk. This raises the next question – why would the perception of interest rate risk suddenly go up now?

We conjecture that this could be a result of the manner in which the RBI has been managing interest rates in the government bond market. The Covid-19 pandemic presented the Indian economy with an unprecedented challenge. A combination of falling tax revenues and rising expenditure on account of fiscal stimulus resulted in a massive increase in the fiscal deficit of the government, and a corresponding rise in government borrowing from the bond market. In 2020-21 the consolidated government borrowing was a whopping Rs 21.5 trillion and the planned borrowing for 2021-22 is roughly Rs 19.6 trillion. The overall government debt to GDP ratio is roughly 90 percent, the highest ever.

The RBI on its part has taken multiple steps to ensure that interest rates are kept low in the bond market so that the government’s cost of borrowing remains under control. It has allowed several primary auctions of G-Secs to devolve on primary dealers and has even canceled auctions when it did not receive bids at rates that were low enough. In addition to its standard open market operations (OMOs), it initiated the Operation Twist program whose objective was to bring down interest rates at the long end of the yield curve and push up rates at the short end. This meant that the RBI was buying long-dated G-Secs and selling shorter maturity bonds.

In March 2021 the RBI launched a program called the G-SAP wherein for the first time it pre-committed to buying a specific amount of G-Secs. These bond market interventions are mostly aimed at capping the interest rate on the benchmark 10-year G-Sec at 6 percent. As a consequence of these actions, the RBI has ended up owning a substantial amount of the 10 year benchmark government bonds (link).

It is possible that bond investors believe that the RBI will not be able to suppress the interest rates for too long, and the rates will rise sharply and suddenly. This could be either because of the large volume of G-Secs the government needs to issue to finance its deficit or because of growing inflationary concerns in the Indian economy (CPI inflation has exceeded the upper limit of 6 percent of the RBI’s targeted inflation band in both May and June 2021), or because of external factors such as rising inflation in the US.

This is akin to a spring that has been forcefully compressed but can bounce back anytime. If the rates suddenly go up, holding fixed coupon bonds will lead to losses, as explained earlier. This increased risk perception might be one possible explanation as to why the investors now prefer floating rate bonds.

Arguably, another unintended consequence of the steps taken by the RBI to lower the long-term G-Sec yields and suppress the organic evolution of the yield curve in response to market forces may have been that the bond market participants have lost confidence in the yield curve.

In the past whenever inflation went up, 10-year G-Sec yields would also go up, implying a positive correlation between the two variables. The underlying idea is that rising inflation is usually followed by a tightening of the monetary policy stance which in turn leads to higher long term bond yields.

For instance, figure 1 below plots the 10-year G-Sec yield alongside CPI (consumer price index) inflation from 2004-05 to 2013-14. This was a period of high and rising inflation. CPI inflation went up from 3.8 percent in 2004-05 to more than 10 percent in 2012-13. Concomitantly, the 10- year rate went up from 6.6 percent in 2004-05 to more than 8 percent by 2012-13.

Figure 1: CPI Inflation and 10year G-Sec yield, 2004-05 to 2013-14

But recently this correlation seems to have broken down. We can see this clearly in figure 2, which plots the two series using monthly data, focusing on the period from March 2020 to June 2021. CPI inflation began rising from May 2020 onward. It consistently breached the 6 percent upper limit of the RBI’s targeted inflation band during the period April-October 2020, increasing from 5.8 percent in March to 7.6 percent in October. More recently it went up from 4.2 percent in April 2021 to 6.3 percent in June 2021.

Figure 2: CPI Inflation and 10year G-Sec yield, March 2020 to June 2021

However, this time around, rather than increasing, the 10-year G-Sec yield actually fell from 7.5 percent in April 2020 to 5.8 percent in May, since then holding more or less steady around 6 percent. These developments suggest that G-Sec rate might be distorted by the RBI’s interventions, which in turn might explain why some investors are turning to the T Bill rate as a preferred reference rate.

Other explanations are, of course, possible. The rise of floaters could also be a result of companies expecting interest rates to come down, in which case they would not want to issue long-term debt at higher rates. This however seems unlikely. Given that inflation continues to be a concern, interest rates are more likely to go up rather than down, and sooner or later RBI would need to start normalising the surplus liquidity situation that the financial system is currently in.

Alternatively, floaters could be issued if the private sector is tapping a new class of investors, who are interested in buying bonds but do not want to run any interest rate risk. But the issuers of and the investors in the floaters are exactly the same entities that were participating in fixed-rate bond transactions earlier.

Finally, it is also possible that the funding requirements of the NBFCs (the sole issuers of floating rate bonds right now) have undergone some changes which might have increased their preference for these bonds.

Conclusion

We are observing an interesting new development in the corporate bond market. The rise of floating rate bond issuances by private NBFCs, and the use of the 91day T Bill rate as the reference rate seem to indicate a change in the preferences on the part of both issuers and investors.

We conjecture that one reason that might explain this development is the intervention in the bond market by the RBI to control G-Sec yields. Specifically, it is possible that the RBI’s persistent interventions have caused some market participants to lose trust in the yield curve. This possibility needs to be explored further in the future.

If there has indeed been an erosion of credibility in the yield curve, then this would be a serious problem. The yield curve is a fundamental construct in a market economy, as it defines the interest rate structure that is used to price debt. As a result, if the yield curve is distorted, then interest rate risk is being mispriced. The associated misallocation of resources could prove to be costly, damaging the economy just as it struggles to recover from the Covid crisis.

Harsh Vardhan is Executive in Residence at the Center for Financial Studies (CFS) at the SP Jain Institute of Management and Research. Rajeswari Sengupta is an Assistant Professor of Economics at the Indira Gandhi Institute of Development Research (IGIDR). The authors thank Josh Felman and an anonymous referee for their useful suggestions.

Fiscal consequences of shifting an inflation target from 2% to 4%

by Ajay Shah.

Most advanced economies have a nominal anchor for monetary policy in the form of an inflation target at 2%. This has presented difficulties when the policy rate hits 0%. This calls for using a new and more unpredictable tool -- quantitative easing -- or finding ways to force the short rate below zero. Both are difficult.

Some people are proposing that the inflation target should be raised to 4%. This possibility is being posed as a choice between two unpleasant things. On one hand, the smooth working of the economy will be impeded by higher inflation, but on the other hand we have to deal with the zero interest rate lower bound. Ben Bernanke's recent blog article is an example of this debate.

In addition to these arguments, there is a fiscal perspective that needs to be brought on the table.

Suppose we suddenly raise the inflation target from 2% to 4%. Suppose there is no disruption, everything works out smoothly. In the ideal scenario, the yield curve should parallel shift up by 200 bps at all maturities.

This would be bad news for persons holding nominal bonds issued by the government, persons holding nominal pensions, nominal bonds issued by private corporations, etc.

A person who has a nominal pension backed by a corporation will be angry about it. But there will be nothing she can do about it. Persons who hold claims upon the government would not accept these losses lying down. They would organise themselves politically and ask for compensation for the losses they would face if such a decision were taken.

How large are the magnitudes? Suppose a country has explicit nominal government bonds and implicit nominal pension debt adding up to 100% of GDP. Suppose this has an average maturity of 10 years. The 200 bps parallel shift of the yield curve would impose a loss of 20% which works out to 20% of GDP. There is no democracy in which monetary policy wonks are going to be able to impose a cost of 20% of GDP upon some people without a political fight. A negotiation would take place where the adversely affected persons will ask for compensation.

This negotiation will be a difficult one. As an example, envision the US Treasury, the US Fed, and bondholders sitting in a room arguing about 20% of GDP. Things become more difficult in countries where the government owes nominal defined benefit pensions.

If the negotiation works out smooth and clean, the debt/GDP of the country goes up by 20 percentage points. This will make bondholders and credit rating agencies more nervous about the fiscal solvency of the country. While some countries (e.g. Australia) have good fiscal health, most advanced economies do not.

The last and most troublesome issue is that of credibility and confidence. Many advanced economies have a difficult fiscal situation, particularly when off-balance-sheet liabilities are counted. The bond market has generally been quite well disposed towards these countries; e.g. the bond market assumes the US will solve its fiscal crisis, even though nobody can see how this would be done. One key element of this confidence on the part of the bond market is: trust in the 2% inflation target. As fiat money is anchored with a 2% inflation target, the fiscal authority cannot inflate away debt by using inflation surprises. This reassures bond holders who are then willing to lend money to the sovereign at low interest rates.

Suppose the negotiations associated with the increase in the inflation target don't work out well. Some bondholders walk away feeling they were unfairly forced to accept a loss. There will be less trust the next time around. The bond market will not trust the 4% inflation target in the way it has come to trust the 2% inflation target. It will demand a risk premium in exchange for bearing the risk that the institutional mechanism of monetary policy is not trusted for decades and decades to come.

For some advanced economies, under certain kinds of mishandled negotiations, the project of trying to raise the inflation target from 2% to 4% could lead to a sharp one-time increase in the debt/GDP ratio and a higher required interest rate for government debt. These two outcomes could significantly worsen the fiscal situation for the government.

These considerations should be brought into the picture when evaluating the costs and benefits of raising the inflation target from 2% to 4%.

On related issues, this article from June 2009 has worked out reasonably well. One change that intervened was that the US moved closer to formal inflation targeting in 2012, thus removing some of the concern.


I acknowledge useful discussions with Josh Felman on these issues.

The gains from sound macro and finance policy

by Ajay Shah.

Israel went through a complete transformation of macro and finance policy. They started out pretty bad, and put in all the key machinery : inflation targeting, floating exchange rate, open capital account, modern financial regulation, public debt management, etc.

A graph of the nominal yield curve for government borrowing is quite revealing [source]. It superposes the yield curve prevalent at many dates:

The curve at the top is the yield curve in October 1996: it goes out to only 3 years, and features nominal rates of 16 to 17%.

Through the years, as the macro and finance reforms fell into place, nominal interest rates for borrowing went down, and the maturity went up. By January 2012, inflation had stabilised at the target of 2%, the short rate was 1.5%, and the 30 year rate was 5.51%.

Note that the 2012 situation is without financial repression and without capital controls. Private persons voluntarily choose to lend to the government, for a 30 year horizon, at 5.51%. There are no other distortions in the picture. This is the `fair and square' cost of borrowing for the government.

This shows the the direct gains to the fiscal authority from doing the orthodox approach to macro and finance policy. Similar large gains became available to the private sector, as corporate bonds and bank loans are expressed as credit spreads off the government bond interest rates. We in India will get these gains by enacting and enforcing the Indian Financial Code.

What is the role of WPI in monetary policy?

by Jeetendra.
 
The RBI just can't seem to catch a break. Try as it might, it just can't seem to escape controversy, even over issues that in other countries are not exactly controversial. Take the case of which particular inflation index the RBI should use as its target. For an entire decade, people debated ferociously over whether the target should be the  CPI or the WPI. Finally, about a year ago it seemed that all the arguments had been exhausted and a consensus had been reached that the CPI was best. So, Governor Rajan announced that henceforth the RBI would target the CPI.

Case closed? Not at all! It turns out that reports of the debate's death had been greatly exaggerated. On July 9 the Business Standard reported that a growing chorus of businessmen and analysts are complaining that CPI targeting has led the RBI astray, causing it to set interest rates too high. They want the RBI to target the WPI, which shows that prices are actually falling.

Did the RBI make a mistake? To answer this question one needs to go back to basics, and think about what monetary policy is trying to achieve.

The main goal of monetary policy is to provide a particular service to the population, the service of ensuring stable prices. This task is of such importance that the RBI was set up as a special institution, organisationally distinct and geographically separate from the government. When that set-up did not prove sufficient to safeguard low inflation, further reinforcements were put in place. The RBI adopted a formal inflation targeting regime, and the government in turn promised to provide the central bank with the operational independence needed to achieve the agreed inflation target. The Monetary Policy Framework Agreement, which was signed by Finance Secretary Rajiv Mehrishi and RBI Governor Raghuram Rajan on 20 February 2015, creates this formal arrangement. All this is being done because price stability is critical to the welfare of the population, especially the weaker sections who suffer badly whenever the prices of their necessities rise.

So far, so good. The problem comes when one needs to translate the universally agreed objective of price stability into a specific monetary policy stance. To do this, one needs three things. First, a specific measure of inflation. Second, a definition of what it means for this measure to be “stable”. And third, a framework (which could be based on an econometric model) for deciding what level of interest rates would best achieve the inflation objective.

In other countries, most of the debate has centred on the third issue, whereas the first two have proved relatively easy to address. Virtually all inflation targeting central banks define price stability as inflation somewhere between 2 percent and 5 percent. And they measure inflation using the CPI, because the objective is to improve consumer welfare, and the index that measures the price of consumption goods is the CPI.

In contrast, WPI is only distantly related to consumer welfare. For a start, it is unclear what the WPI is actually measuring. Its coverage is extremely limited, encompassing only the commodity-producing sectors and completely ignoring services, which constitute more than half of the economy. The few sectors that are included are then weighted according to their gross value of production, not their value-added. Consequently, the index is deeply unrepresentative of the economy.

But let’s suppose the RBI were prepared to ignore these theoretical issues. It would run immediately into some very practical difficulties. Since the WPI consists mainly of commodities, the movement of this index is heavily influenced by developments in world markets, which the RBI cannot control. The RBI cannot determine the dollar price of oil. And while it can influence the rupee price by controlling the exchange rate, this is a dangerous strategy, as the East Asian countries discovered at their peril in the late 1990s, when their exchange rate pegs collapsed in crisis. So, the reality is that the RBI cannot control the WPI, and should not try to do so.

Does that mean the RBI should just ignore the WPI? Not at all. Recall that achieving price stability – even if measured solely by the CPI – requires a framework for figuring out what level of interest rates is required to obtain this objective. And this is where the WPI does indeed come in, as do various other measures of prices.

Just not in the way that the analysts quoted in Business Standard argue. According to them, interest rates have been set on the premise that the economy and inflation are proceeding apace (as indicated by the rising CPI), whereas in reality manufacturers' prices are falling (as shown by the declining WPI). So firms are getting squeezed between high interest rates and low prices.

Firms may well be suffering from a profit squeeze. In fact, the corporate results suggest they are. But you can’t prove this by citing the WPI. That’s because the WPI does not measure output prices, the prices at which firms are selling their goods. The index that does this is the PPI, or producer price index, which unfortunately does not exist for India. Rather, the WPI is essentially a measure of input prices, because it consists mainly of commodities, which are largely inputs into production. Accordingly, a falling WPI actually increases firms' margins, improving their profitability. (Think: oil.) As a result, there’s no need, at least not from the falling WPI, to compensate firms in the form of lower interest rates.

That said, there is a kernel of truth in what the Business Standard analysts are saying. To see this, let’s go back to basics again. Very broadly, inflation occurs when aggregate demand exceeds aggregate supply. And aggregate demand is influenced by many factors, including many different price indices. Consumption decisions depend in part on interest rates adjusted for CPI inflation. Export demand depends partly on interest rates less export price inflation. And investment demand is influenced by the difference between interest rates and PPI and WPI inflation. Summing up all of these factors is impossible to do intuitively. That’s why central banks employ large econometric models to guide their policymaking.

So, in the end, the analysts quoted in Business Standard have a point. The WPI and its attendant data bank of price time series, should be taken into account, indeed perhaps is already taken into account, in the RBI’s policy-making framework. But it cannot be the object of this framework. The sole inflation target should be, indeed must be, the CPI. After more than a decade, it is really time to put this debate to rest.

India macro policy review

On 19 November, we have a day-long meeting, India Macro Policy Review at NIPFP. All are welcome.

Was it worth picking a battle on the rupee?

For the last month, financial and monetary policy has pursued the goal of preventing rupee depreciation. I have a column in the Economic Times today titled Should we have picked this battle?

Is this a time for monetary policy easing?

`Headline inflation':
The year-on-year change in CPI-IW,
with target zone superposed.

The best price index in India is the CPI-IW. `Headline inflation' in India corresponds to the widely watched year-on-year change in the CPI-IW. The above graph shows us the experience of inflation in India from 1999 onwards. The informal target of policy makers is for inflation to lie between four and five per cent. These are the two blue lines on the graph.

In February 2006, inflation breached the upper bound of five per cent. It has never come back in range. Things are so bad that even the overall average inflation of this period (the red line) is now above the upper bound of five per cent. We don't just occasionally fail to stay within the target range of inflation; we persistently fail to get there. This inflation crisis is a major failure in Indian macroeconomic policy, and is holding back India's growth.

Many explanations like supply side factors or droughts are offered. They fail to persuade when we see this time-series experience. Did we have fewer droughts before 2006? Or that supply side factors were not a problem before 2006? Sustained failures on inflation are always rooted in monetary policy. In the long run, inflation is always and everywhere a monetary phenomenon.

There is some tiny progress in the latest months in this graph, but we cannot claim that the inflationary spiral has been broken. Policy rates are 7 and 8 per cent, and inflation is almost surely above 8 per cent, so the policy rate is likely to be negative when expressed in real terms.

Smoothed month-on-month inflation
(annualised, based on seasonally adjusted CPI-IW)

The year-on-year change is a moving average of the latest 12 month-on-month changes. We obtain information about current conditions by looking at more recent month-on-month changes. This requires seasonal adjustment. The graph above shows the 3-month moving average (3mma) [source]. Just as the y-o-y change shows average inflation over the latest 12 months, this graph shows average inflation over the latest 3 months.

There is some progress in recent months. But at the same time, in the entire period, we see many such short periods of decline in inflation. Eyeballing the graph does not give us confidence that there has been a qualitative change in inflationary conditions. As an example, consider the previous dip in inflation. We could have become quite excited by the drop in this 3mma CPI-IW inflation down to 2%. But this was a temporary gain which was quickly reversed.

We should hence be cautious about reading too much in the recent decline in month-on-month CPI-IW inflation. While it is great news if inflationary pressures in the economy are declining, and it will be great news when the cycle of high inflationary expectations will be broken, there isn't enough evidence as yet to announce that the mission -- of achieving low and stable inflation -- has been achieved.

India's inflation crisis, and what this means for monetary policy

The graph above shows headline inflation in India, i.e. year-on-year CPI-IW inflation. The informal target zone for policy makers in India is to have year-on-year CPI-IW inflation between four and five per cent. This is shown on the graph as blue dashed lines.

From February 2006 onwards, inflation breached the upper bound of five per cent. It has never come back below five per cent. The red line shows the overall average inflation from 1999 to today: it is well beyond the upper bound of five per cent. If our informal goal was to get inflation between four and five per cent, we have failed to do this as measured by average inflation from 1999 onwards (averaging across both good periods and bad).

Our loss of price stability is a major weakness of macroeconomic policy. It has far reaching consequences and hampers the extent to which the economy is able to get back onto a stable growth trajectory.

That's the big picture. Now let's look at current inflationary pressures. For this, we must look at the month-on-month annualised changes in the seasonally adjusted CPI-IW. This data shows difficulties in 2012:

Jan	8.68
Feb	13.22
Mar	17.88
Apr	20.22
May	8.62
Jun	7.78
Jul	7.18
Aug	13.06

The target -- year on year CPI-IW inflation -- is the moving average of the latest 12 values of month-on-month inflation. If we hope to get y-o-y CPI-IW inflation below 5 per cent sometime in the coming six months, then the latest six months should contain good news. But there isn't a single month of data in 2012 where the month-on-month CPI-IW inflation was within the target zone of four to five per cent. It is, hence, likely that we're atleast a year away (if not more) for y-o-y CPI-IW inflation to drop below 5 per cent.

Inflationary expectations are in excess of 10 per cent; the policy rate expressed in real terms is negative. Under these conditions, I fail to see how many people are thinking it's time for RBI to cut rates.

As India becomes a middle income economy, and experiences business cycle fluctuations, we're going to require a quantum leap in the institutional and human foundations of macroeconomic stabilisation. One key component of this is an institutional commitment at RBI to deliver low and stable inflation.

Some argue that private sector confidence, and stock prices, will be boosted by a rate cut. Will it? Will the private sector be impressed by a display of low institutional capacity? Will lower rates foster investment? I'm curious to see how this will work out.

The disaster at Maruti

The news from Maruti is disgusting. I have been curiously watching how the stock market takes it in:

That Maruti has serious labour problems has been known for a long time. But the brutality that unfolded in recent days was out of the world. It was news. When I read about it on Thursday, it seemed to me that Maruti was facing a Tata Motors style situation: of suffering the fixed cost of closing down the existing plant and relocating to a state with better governance. The costs faced in this would be substantial. In that case, a 6 per cent decline of the stock price seemed pretty modest. I watched the small recovery on Friday with surprise. Surely, the cost and complexity of moving out of Manesar is worse than 5%.

Today, on Monday, the market has shifted from a less sanguine assessment to a 10% drop in the stock price. I wonder if this is new information or a modified judgment about how this will play out. Were the speculators on late Friday evening just wrong, or did some new information break?

Bad macroeconomic outcomes and social stress

I would conjecture that poor macroeconomic performance -- low GDP growth and high inflation -- is correlated with greater stress of this nature. With inflation, the logic is straightforward: The worker who had a nominal wage contract finds the need to renegotiate when the value of the rupee changes. This links back to the earlier discussion here on why solving India's inflation crisis is important. Too often, we in India are cavalier about inflation. But we should see inflation as an acid that corrodes all nominal contracts, whether stated or unstated. Renegotiation is costly.

Turning to GDP growth, most people that I know seem to think that a couple of per cent of real per capita GDP growth is important for keeping the peace. A lot of people become a lot more unhappy when growth slows. Indian democracy does a pretty good job of containing the angst. There will be no revolution here. But life is substantially easier if the engine of GDP growth is purring. When it stalls -- as it appears to have done in 2012 -- a whole host of social problems erupt.

Law and order as the fundamental foundation of civilisation

This is a reminder to us about how law and order is the fundamental precondition of civilisation. The most important public good of all, the first claim on the resources of the State including the time and attention of the senior leadership, is police, courts and laws. The entire story of the market economy and high GDP growth can only come about when safety of life and property is guaranteed. The events in Maruti are an important reminder to every investor about the weaknesses of governance in Haryana.

In tracking conditions in any state, I find it useful to watch the time-series of the share of the state in the overall all-India investments outstanding, that are `under implementation', in the CMIE Capex database. Here's an example, for Bihar:



November 2005 is the date that Nitish Kumar became the new CM of Bihar. He is widely reputed to have made important progress on improving law and order. At first, the share of Bihar (in all-India under implementation investment) continued to drop. I am sure the changes brought about by Nitish took time; Rome wasn't built in a day. And, after improvements come about, skeptical investors would take some time in making up their minds that conditions are now better. From 2009 onwards, it appears that there is some upward movement. The overall gain seems to be roughly 1 per cent of the all-India total, which is a significant change.

Compare this with Haryana:

There was a big spurt in the share of Haryana in the overall under-implementation investment in India. After that, the numbers have steadily trended down. Is Haryana suffering from a resource curse in terms of proximity to Delhi?

Rethinking labour law

In the early decades about independence, India constructed a remarkable legal framework which was strongly pro-trade-union. Few countries have enshrined trade unions into laws on the scale that India has done. In those years, trade unions were primarily led by socialist/communist parties. While we may disagree with their views, there was a fundamental decency about them. Some of the best human beings in India, in the 1950s and 1960s, were communist. Perhaps this coloured our thinking, and encouraged us to respect and empower trade unions strongly in the legal framework which fell into place over the 1960s and the dark days of the 1970s.

Today, a hyper-empowered trade union is a potent tool for extortion in the hands of local goons. To solve this problem, it is important to rethink the checks and balances embedded in labour law, which have gone too far in the direction of making trade unions strong. Now that we know that the people in trade unions are most likely local goons, do we want to hyper-empower them through labour law?

Why is solving India's inflation crisis important?

by Ajay Shah.

All of us are aware of India's inflation crisis. It is very disappointing, how we lost our grip on stable 4-to-5 per cent inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5 per cent.

All of us agree that there is something insiduous when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument "Yes, this is bad, but if high inflation is the way to get to high GDP growth, let's get on with it". It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important

Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Every society needs to adjust all the time, in response to changes in tastes and technology. When tastes or technology change, the structure of production needs to change, which involves renegotiation of (written or unwritten) contracts. These adjustments are costly. Contracting is costly, and renegotiating contracts is costly.

It is useful to think of a finite supply of adjustment as being available in the country. We should devote that full power of adjustment to the beneficial adjustments associated with changes in tastes and technology. In a place like India, where GDP doubles every decade, the requirement for adjustment is (in any case) large.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Contracting is costly. Almost everything that senior managers do is to arrive at complex deals that create and sustain complex structures of production. This work is continually torn down by high inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.

Inflation messes up information processing

To continue on the theme of adjustment, the essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise' by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Building a sophisticated market economy is all about making long-term plans. When a firm decides to build an airport or a highway, this involves making NPVs over the next 20-40 years. This requires having a fair idea about future inflation. If inflation will fluctuate in the future, then firms will err on the side of caution when making plans about the future, i.e. investment will be reduced. I will stress that long-term investment, in projects such as infrastructure or heavy industry, relies critically not just on a long-term bond market (which, in turn, critically requires low and stable inflation) but also on the calculations happening in a spreadsheet about the NPV of the investment project, which involves projecting all revenues and all expenses for the next 20-40 years (which also critically requires low and stable inflation).

Impact upon pre-existing nominal savings

For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

A civilised society is one in which people can make plans for the deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of even one bout of high inflation over the coming 25-35 years forces people to drop back to other mechanisms of protecting themselves in old age. What is needed is not just inflation control right now. What is needed is the environment of mature market economies, where outbursts of inflation are fully ruled out for decades to come.

Impact upon relationship with banks

In India, banks pay very low interest rates. While many interest rates have been deregulated, the interest rates paid by banks are held back by factors such as low competition and financial repression (i.e. forced purchases of government bonds).

When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, households tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

If the financial system were regulated sensibly, then with high inflation we would immediately get higher nominal interest rates since buyers of 90 day treasury bills would demand higher interest rates to pay for inflation. This would reduce the damage caused by high inflation. In India, we suffer from bigger negative effects because of a faulty financial system.

These may seem to be small things but they actually are fairly large effects. Towards an understanding of the costs of inflation -- II, by Stan Fischer, 1981, argues that perfectly anticipated 10% inflation induces a cost of 0.3% of GDP on account of only one factor : excessive efforts by households and firms to hold less cash.

The rising prominence of gold

Gold is a barbarous relic; it is the investment strategy of choice for uneducated people. It is also a vote of no confidence in fiat money. Our failures in creating a capable central bank, which delivers sound fiat money, are taking Indian households back to their old ways. Many decades of progress in getting households to engage with the modern financial system is being undone in this inflation crisis.

A classic quotation

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become `profiteers', who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. 

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.

From Chapter 6 of The Economic Consequences of the Peace, by John Maynard Keynes. Source: Who said ``Debauch the Currency'': Keynes or Lenin? by Michael V. White and Kurt Schuler, Journal of Economic Perspectives, Spring 2009.

But is there not a tradeoff between growth and inflation?

For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here's the classic picture, for the 1960s in the US:

which shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The idea that there is a tradeoff between inflation and unemployment is thus an artifact found in the minds of people who studied economics in the 1970s. This proposition was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

In the empirical literature, it is quite clear that by the time we get to double digit inflation, this has a discernable and negative impact on growth. This generally means that at a 95 per cent level of significance, you can reject the null of no effect, in conventional datasets. The conceptual reasoning above gives no reason for believing that there should be a threshold effect, that inflation above 10% should hurt growth but below 10% things should be fine. It could well be the case that when you get to smaller values for inflation (e.g. 9%) this effect size is not detected with conventional datasets at the 95 per cent level of significance.

It is interesting to look at the target inflation rate set in the numerous countries which have setup either de facto or de jure inflation targeting. The median value chosen has been: 2%. If people were convinced that inflation below 10% is not damaging to growth, inflation targets may have been higher. But instead, the typical inflation target in the world is 2%. This underlines the universal consensus in favour of targeting low inflation -- more like 2% and far below the 10% that we've got stuck with in India.

In the West, some people with a weak grip of economics, and strong sympathy for the unemployed, have argued that high inflation is a good thing because it helps reduce unemployment. In contrast, in India, economists have consistently found that the poor are adversely affected by inflation. There has not been a left-of-centre lobby that is soft on inflation, here.

Conclusion

There is no tradeoff between inflation and growth.

High inflation damages growth.

One element of India's growth crisis is India's inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India's welfare. RBI is in charge of India's fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4 to 5 per cent range.

Low and stable inflation is an essential ingredient of the foundations of high economic growth in India. RBI can lay that platform. They can do no more. If they try to reach into other objectives, they damage this core.

RBI's rate cut

Watch me talk about it on CNBC-TV18.

The inflation crisis has not ended

The most important measure of inflation in India is the year-on-year change of the CPI-IW index. This time series, for 120 months, is shown above. From 2006 onwards, India slipped into a new phase of macroeconomic instability, where inflation has strayed far outside the informal target zone of inflation at four-to-five per cent.

Has inflation subsided?

In recent months, there has been a surge of optimism that the inflation crisis is coming to an end. However, a careful look at the seasonally adjusted data reveals that there is cause for concern.

Month	P-o-p SA	Y-o-y
Sep 2011	17.49	10.06
Oct 2011	2.01	9.39
Nov 2011	3.11	9.34
Dec 2011	-2.14	6.49
Jan 2012	8.22	5.32
Feb 2012	12.01	7.57

In September 2011, point-on-point seasonally adjusted (annualised) inflation was at 17.49 per cent. The year-on-year inflation was running at 10.06%.

We then had three good months: October, November and December, where the point-on-point seasonally adjusted (annualised) inflation dropped to 2.01, 3.11 and -2.14 per cent. This yielded a sharp decline in the year-on-year inflation to 6.49 per cent in December 2011 and further to 5.32 per cent in January 2012.

But after that, things haven't gone well. Point-on-point seasonally adjusted inflation, which is the thing to watch for in understanding what is happening every month, is back up to 8.22 per cent in January 2012 and 12.01 per cent in February 2012. Year-on-year inflation is back up to 7.57 per cent in February 2012.

A casual examination of the key graph (shown above) shows that the worst of double digit inflation seems to have ended. But we are not inside the target zone of 4 to 5 per cent, and neither are we likely to achieve this in the rest of this year. It would be unwise to declare victory over the inflation crisis, with this information set in hand.

Looking forward

Looking forward, there are two main problems worth worrying about. The first is the expectations of households. At the heart of India's inflation spiral is the problem that the man in the street has lost confidence that inflation will stay in the four-to-five per cent target zone. Survey evidence about household expectations has shown double digit values. This generates persistence of inflation; idiosyncratic shocks tend to not quickly die away. The mistrust of households is rooted in the lack of commitment to low and stable inflation at RBI, and this problem is not going to go away quickly. Despite all the problems faced in fighting inflation, RBI continues to communicate, through speeches and official documents, its lack of focus upon inflation.

The second problem is that of the exchange rate. Exchange rate depreciation feeds into tradeables inflation. With a large current account deficit, with policy impediments putting a cloud on capital inflows, rupee depreciation has taken place and may continue to take place. This would be inflationary. Indeed, if RBI chooses to cut rates on the 17th, there will be further weakening of the rupee (since the interest rate differential will go down thus deterring debt flows), which will further exacerbate tradeables inflation.

The media and financial commentators treat it as a given that on 17th, RBI will cut rates. However, the outlook on inflation is worrisome. India's inflation crisis, which began in 2006, has not ended. Year-on-year CPI-IW inflation has not yet got into the target zone of four-to-five per cent, nor is this likely to happen anytime soon.

Our thinking on this needs to factor in the general elections, which are looming at the horizon in May 2014. Given the salience of inflation in India for the poor, the ruling UPA coalition is likely to be quite concerned about getting inflation back to the informal target zone of four-to-five per cent, well ahead of elections. This also suggests that the time for hawkish monetary policy is now, so as to get inflation under control by mid-2013, well in time for elections in mid-2014.

A historical perspective

Inflation went out of control in 2006/2007 because RBI's pursuit of the exchange rate peg required very low interest rates at a time when the domestic economy was booming. (The capital controls that were then prevalent failed to deliver monetary policy autonomy; the only way to get towards exchange rate goals was through distortions of monetary policy). Given the lack of anchoring of household expectations, that inflation crisis has not yet gone away. Today, RBI is substantially finished with exchange rate pegging; we are mostly a floating exchange rate. In the future, inflationary expectations will not get unhinged owing to a pursuit of exchange rate policy by RBI. But while a pegged exchange rate pins down monetary policy, a floating exchange rate does not define monetary policy. RBI has yet to articulate what it wants to do with the lever of monetary policy. The first task for the lever of monetary policy should be the conquest of the inflation that is in our midst, owing to the monetary policy stance of 2006/2007.

In the early 1990s, unsterilised intervention in the pursuit of Rs.31.37 a dollar gave an inappropriate stance of monetary policy, which kicked off an inflation. Dr. Rangarajan wrestled it to the ground, even though the monetary policy transmission was weak then. In 2006, we ignited another inflation, once again owing to exceedingly low policy rates in the pursuit of exchange rate policy. Dr. Subbarao's challenge lies in wrestling this to the ground. His job is easier when compared with what Dr. Rangarajan faced, thanks to the progress which has taken place on financial reforms and capital account decontrol.

Inflation targeting has come to the US

Reportage by Robin Harding and Michael Mackenzie in the Financial Times:

The rate-setting Federal Open Market Committee predicted low interest rates until late 2014 and set a formal inflation objective of 2 per cent, reflecting chairman Ben Bernanke’s long-held goal of providing greater transparency.   

The FOMC downgraded its estimate of growth in the coming quarters from “moderate” to “modest” and Mr Bernanke indicated that another monetary boost for the economy – most likely another round of quantitative easing, or QE3 – remained an option.

“We are prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target,” Mr Bernanke said.

The Fed also published its first detailed forecasts of future interest rates. 

... 

Adopting the 2 per cent objective is a historic move that binds the whole FOMC to a defined goal that will endure after Mr Bernanke leaves. It means the FOMC can easily justify more easing if it wants to because its inflation forecast for 2014, of between 1.6 and 2 per cent, is below target.

The FOMC voted for Wednesday’s decision by 9-1. The only dissenter was Jeffrey Lacker, president of the Richmond Fed, who wanted to leave the late 2014 date out of the policy statement.

The US suffers from legacy legislation, which predates modern monetary economics, which places the burden upon the Fed of pursuing both price stability and low unemployment. The evolution of the US Fed has been led by human energy within the Fed. Starting from Paul Volcker, who took charge in August 1979, the US Fed has run a Taylor rule with a nice strong above-1 inflation coefficient. In a recent column in the Indian Express, Ila Patnaik tells us about Paul Volcker's story and how it matters to us. In effect, from Volcker's chairmanship onwards, the behaviour of the US Fed has been that of an inflation targeting central bank. This was the de facto reality. Everyone knew that the US Fed targets inflation at 2%. What is new now is that the Fed has put greater credibility behind this, by going closer to de jure inflation targeting.

A key dharma of good central banking is to say what you will do, and then do what you just said. By saying that there is an inflation target, there is now full alignment between the words and deeds of the US Fed.

The day will come when India will enact high quality legislation which puts monetary policy on a sound institutional foundation. But we should not accept mal-performance by RBI until that day. It is possible for RBI to do much better, when compared with the present, even though the present legislation is really badly written. The US Fed is a good example of how technical capabilities within the Fed, and not an external legislative mandate, have driven improvements in the functioning of the Fed. This sort of progression is what RBI can and should aspire to, and this does not require waiting for a high quality RBI Act.

Are the inflationary fires subsiding?

On 25 October, Dr. Subbarao announced a 25 basis point hike in the policy rate. Alongside this, he made statements that were widely interpreted as being dovish:

Keeping in view the domestic demand-supply balance, the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2012 is kept unchanged at 7 per cent. Elevated inflationary pressures are expected to ease from December 2011, though uncertainties about sudden adverse developments remain.

 ...

Inflation is broad-based and above the comfort level of the Reserve Bank. Further, these levels are expected to persist for two more months. ... However, reassuringly, momentum indicators, particularly the de-seasonalised quarter-on-quarter headline and core inflation measures indicate moderation, consistent with the projection that inflation will begin to decline beginning December 2011.

... 

The projected inflation trajectory indicates that the inflation rate will begin falling in December 2011 (January 2012 release) and then continue down a steady path to 7 per cent by March 2012. It is expected to moderate further in the first half of 2012-13. This reflects a combination of commodity price movements and the cumulative impact of monetary tightening. Further, moderating inflation rates are likely to impact expectations favourably. These expected outcomes provide some room for monetary policy to address growth risks in the short run. With this in mind, notwithstanding current rates of inflation persisting till November (December release), the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted.

WPI inflation is not interesting in thinking about monetary policy. The WPI basket is not consumed by any household. The right measure of inflation that all of us should focus on is the CPI.

We just released an updated batch of seasonally adjusted data, and the news for inflation, for September 2011, is bad. CPI-IW grew at an annualised (seasonally adjusted) rate of 20.15% in September 2011. As a consequence, the 3-month moving average inflation went up from 8% in August to 11.77% in September.  If we compute the policy rate as the halfway mark (8%) and subtract out this latest value of the 3-month moving average inflation rate (11.77%), the policy rate expressed in real terms is -377 basis points.

Here's the picture of what's been going on with point-on-point seasonally adjusted CPI-IW inflation:

The key fact about India's inflation crisis is: "Headline inflation", which I would define as the year-on-year rise of CPI-IW, has been outside the target range of 4-5 percent in every single month from February 2006 onwards. High inflationary expectations have now set in. Given what is happening on prices of both tradeables and non-tradeables, I find myself skeptical about the sanguine picture on inflation that was painted on 25 October.

The bottom line: Headline inflation (year-on-year rise of CPI-IW) went up from 8.99% in August to 10.06% in September. This is inconsistent with a sanguine analysis of inflation on 25 October.

Or perhaps the econometricians at RBI have some aces up their sleeves. Will point-on-point seasonally adjusted inflation, under the benign influence of a strongly negative real rate, veer back into the 4-5 per cent range by December 2011? Stay tuned. So far, the score is: September 2011, 20.15%.

Fighting back inflation is cheaper when there is credibility: A numerical example

A few days ago, I wrote a blog post about India's inflation crisis. For five years now, in every single month, the y-o-y CPI inflation has exceeded 5%. Under these conditions, economic agents have little confidence that RBI cares about inflation. They are now reporting double digit inflationary expectations. Under these conditions, inflation will be persistent. By itself, inflation is not going to go back to the target range of 4 to 5 per cent. This blog post made certain qualitative claims about fighting inflation under two scenarios: when the central bank has credibility and when it does not.

I recently came across a fascinating paper which is about a similar situation: it is about the problems faced in Ghana recently, in fighting back an inflation. It gives numerical values which are interesting for us. Their inflation was a bit worse than ours - they were at 20%. But for the rest, this analysis illuminates what we face in India today. The paper is : A model for full-fledged inflation targeting and application to Ghana, by Ali Alichi, Kevin Clinton, Jihad Dagher, Ondra Kamenik, Douglas Laxton and Marshall Mills, IMF Working Paper, 2010.

Here is the main story. First, look at the projected trajectory for what happens to the short term interest rate and inflation under conditions of weak credibility of the central bank:

The nominal rate is required to go all the way out to 26%. Inflation responds slowly. It is projected to get to the target (with some overshooting at first) by 2016. The cumulative damage to GDP growth, in this process of exorcising inflation, works out to roughly 20 per cent of GDP. (This is the sum total of the output cost over all the years taken in wrestling this inflation down).

Compare this against the picture obtained when the central bank has high credibility:

This is much nicer story. The nominal interest rate starts out high (18%) but inflation responds rapidly and the interest rate can also come down rapidly. By 2013, inflation is at the target. The cumulative damage to GDP growth, in this process of exorcising inflation, works out to only 4% of GDP.

This difference is striking. Lacking credibility, the central bank has to force a total output loss of 20% of GDP, and they get to target inflation by 2016. With credibility, the job gets done three years sooner, and at a cost of only 4% of GDP of output loss.

This is an essential insight into our inflation crisis today. In the end, raising rates will get the job done. No matter how bad is the monetary policy transmission, no matter how deeply ingrained inflationary expectations have become, raising rates will ultimately deliver price control. The choice that we face is between being bloody-minded about it, or simultaneously undertaking RBI reforms which involve zero output loss, and improve RBI's credibility.

The inflationary spiral

When prices are written with a piece of chalk, menu costs are low

Reining in the inflationary dragon

A lot is being written about inflation in India today. I thought it's worth writing about the fascinating insights into inflation that come from focusing on the distinction between tradeables and non-tradeables.

What is a tradeable

A tradeable is a product which can be transported across the world at relatively low cost. As an example, steel is tradeable while cement or paint are mostly non-tradeable barring special short-hop opportunities like Gujarat-Karachi or Amritsar-Lahore or Calcutta-Chittagong or Trivandrum-Colombo.

Steel is a nice tradeable that one can think clearly about. There are no barriers to the movement of steel worldwide. Hence, there is only a world price of steel. The quoting convention used worldwide is to express the price of steel in USD. The price of steel in India is thus the world price of steel multiplied by the INR/USD exchange rate, plus a markup for freight (The cif/fob ratio).

If there is a customs duty of (say) 10%, then the price of steel in India is 1.1 times the world price of steel expressed in rupees. For the rest, nothing changes when a customs duty is introduced. Gram for gram, every fluctuation in the INR/USD or the world price of steel shows up in the domestic price of steel.

Non-tradeables are things like cement (which are hard to transport) or haircuts (which are impossible to transport).

Measurement

Before we can analyse and control inflation, we must measure it well. Inflation is defined as the rise in the price of the average household consumption basket. The CPI is the best measure of inflation in India.

Everything in the CPI basket can be classified into the two categories: tradeable vs. non-tradeable. As a thumb rule, WPI non-food non-fuel is a rough measure of tradeables inflation. Fluctuations in food and services prices, which make the CPI diverge away from WPI non-food non-fuel, are a measure of non-tradeables.

Year-on-year inflation reflects an averaging over 12 months. If you want to get a faster sense of what is going on, you need to look at point-on-point seasonally adjusted changes. These yield early warnings of inflation, which are 5.5 months ahead on average. Such data is updated every Monday by us. The shift from y-o-y inflation, to p-o-p SA inflation, is a free lunch in measurement and monitoring.

The WPI is a useful database of many price time-series in India. But the overall WPI is useless in thinking about inflation in India: there is no household in India which consumes the WPI basket.

The use of WPI inflation, and the exclusive use of y-o-y inflation, are litmus tests of professional competence in the Indian landscape.

The function of the central bank

The job of RBI is to deliver low and stable inflation: to deliver y-o-y CPI inflation of between 4 to 5 per cent.

They have failed in this task. From February 2006 onwards, in every single month, y-o-y CPI inflation has exceeded 5 per cent. This is an important time for introspection at RBI and outside it. What have we done wrong, in the structuring of RBI, which has got us into this mess?

It is useful to think of this as a principal-agent problem. The people of India are the principal. RBI is the agent. The principal hires the agent and gives him resources. In return, the agent has to be held accountable. Delivering low and stable inflation is the accountability mechanism. It is a quantitative monitorable measure of the performance of the central bank. That we have sustained failure on this function, from February 2006 onwards, suggests that we should be modifying the nature of the contract between the principal (the people of India) and the agent (RBI).

How RBI can influence the price of tradeables

RBI has absolutely no say on the world price of steel. In that sense, the prices of tradeables are beyond the control of RBI.

When RBI raises the interest rate, more capital comes into India, which tends to give an INR appreciation, thus making tradeables cheaper. Thus, an RBI rate hike does impact upon the domestic price of tradeables.

It is also worth pointing out that the central banks of most major countries are high quality inflation targeters. They deliver on their mandate of delivering low and stable inflation. As a consequence, inflation in the global tradeables basket tends to be low and stable. Tradeables prices are a helpful source of price stability, most of the time.

(That a large part of the CPI basket is tradeable, and seemingly beyond the control of the central bank, is no excuse. There are dozens of high quality central banks visible in the world, with very large shares of the CPI basket in tradeables, who are delivering on inflation targets. We in India should not accept excuses).

How RBI can influence the price of non-tradeables

Non-tradeables reflect aggregate demand and aggregate supply in India. RBI can influence these by raising or lowering the short-term interest rate. When interest rates are made slightly higher, household consumption and investment demand are slightly lowered.

A critical feature of non-tradeables inflation is expectations. If people expect 10% inflation, they tend to wire high price rises into their negotiation of wage and other contracts. This generates inflationary momentum. Particularly in a place like India, where the institutional structure of monetary policy is primitive, economic agents have little confidence in the ability of policy makers to rein in inflation. As a consequence, inflation is highly persistent. Once high inflation sets in, economic agents expect high inflation to continue. There is a great deal of momentum in inflation.

For years now, some economists have argued that inflation will subside by itself. It will not. Inflation does not mean-revert to the target zone of 4 to 5 per cent by itself. We are now in a trap of high inflationary expectations. This structure of expectations will need to be broken. This can happen in two ways. RBI needs to turn a new coat, and convince people that it now cares about inflation without any other conflicts of interest. And, rate hikes have to take place.

There are two paths to inflation control: changing the structure of expectations and reducing aggregate demand. The former is almost a free lunch. It only requires institutional change. The latter is hard work; it inflicts pain.

What about supply factors?

Some argue that supply bottlenecks in India - such as hideous rules about mandis - are the cause of inflation.

The trouble with this explanation is that the supply bottlenecks have always existed. They have existed in high inflation times and in low inflation times. It is, thus, not possible to claim that supply bottlenecks have caused the inflation crisis which began in February 2006.

Can rate hikes deliver inflation control?

When C. Rangarajan was RBI governor, there was an inflation crisis, and rate hikes did deliver on inflation control. The phase of price stability ushered in then lasted all the way till February 2006. This shows us that even in India, it can be done.

We have to remember that in his time, the monetary policy transmission was much weaker than what we see today. With a bigger wall of capital controls, domestic rate hikes did not deliver inflation control by impacting on the INR (through higher capital inflows). With a smaller and weaker Bond-Currency-Derivatives Nexus, the monetary policy transmission from the short rate into aggregate demand was inferior, then. Yet, he got it done.

Conversely, with a very primitive financial system and monetary policy transmission, the central bank of Zimbabwe delivered a nice hyperinflation. We can quibble about the potency of the monetary policy transmission, but we should not doubt the ultimate domination of monetary policy in shaping inflation. In the long run, little else matters in shaping inflation.

Part of the story of the 1990s lies in clarity of purpose at RBI and policy credibility. Rangarajan's period had good quality speeches, which did not dilute the message on inflation control as the dharma of the central bank. In contrast, in recent times, RBI has repeatedly written low quality speeches. To an expert reader, they have conveyed the lack of knowledge on monetary economics at RBI. To the non-expert reader, they have waffled on the subject of taking responsibility, and have encouraged the average economic agent to think that high inflation is here to stay.

Slamming the accelerator while hitting the brakes

The #1 problem of Indian macroeconomic policy is the inflation crisis. From February 2006 onwards, in every single month, inflation has exceeded the target zone of four to five per cent. I'm measuring inflation as the year-on-year change of the CPI-IW. The latter is the best measure of the overall price level in India today.

This macroeconomic instability is damaging the ability of economic agents to plan and invest for the future, because it's hard to envision interest rates and prices when faced with such high uncertainty. High inflation thus damages growth.

Many people in India like to make excuses about inflation. One day, inflation is about the price of onions. Another day, inflation is about a global commodity shock. Many people like to open up the sub-components of WPI and explain away inflation by saying "but it's only concentrated in a few things which make up x% of the overall basket". And so on. While each of these idiosyncratic factors can generate relative price changes, they cannot explain sustained price rise of the overall household consumption basket.

Sustained and persistent inflation is not an act of god. It is made by mistakes in macroeconomic policy. It can and should be contained by solving these problems of macroeconomic policy.

On May 3, Dr. Subbarao announced a fairly good policy statement. It continued to talk about WPI while the best inflation measure is the CPI. But for the rest, it was the first time that RBI was starting to take the inflation crisis seriously. And that was good. Also see an Indian Express column by Ila Patnaik on May 6.

Sadly, RBI's commitment to the problem of inflation lasted for six days. On 9 May, Dr. Subbarao did a speech in Switzerland which essentially robbed RBI's stance of credibility. Ila Patnaik has a column in the Indian Express about the damage that this speech has caused. You might like to also see this old column of mine on the problems of RBI.

Consider the date on which the rate hikes began. Compare two alternative worlds:

• In one world, RBI says: "We care about inflation, we will do what it takes to get y-o-y changes of the CPI-IW back to the target zone of four to five per cent". And the rate is hiked by 25 bps. And this is repeated a short while thereafter. And so on. In this world, the expectations of economic agents get modified alongside the rate hikes.
• In another world, every time RBI raises rates, RBI says "actually we are not so serious about inflation". In this world, the expectations of economic agents do not get modified alongside the rate hikes.

Monetary policy works by directly crimping aggregate demand (e.g. driving up the EMIs that people pay, or the cost paid by firms for working capital) and by reshaping expectations and thus the decisions about wage / price hikes. By damaging the latter, RBI has imposed more of the heavy lifting upon the former.

What does it take for RBI to persuade us that they are serious about inflation? Commitment to the floating exchange rate (thus removing this conflict of interest that can damage monetary policy), movement on the DMO (thus removing another conflict of interest that can damage monetary policy), and sound monetary economics going into speechwriting (and future monetary policy formulation). By failing on all three scores, RBI is generating a situation where there is no commitment that in the future, RBI will fight inflation.

Whether RBI wants it or not, India will fight this inflation crisis, which is the #1 cloud on the horizon of India's macroeconomic policy. The politicians require CPI-IW inflation to be back to the four-to-five per cent zone by late 2013, well in time for the elections in 2014. The pressure is simply going to ratchet up. The only question is about how monetary policy will fight inflation. If the instrument of monetary policy is refashioned to fight inflation, then the amount of pain that has to be inflicted through rate hikes, that is required to get the job done, will be lower. If the instrument of monetary policy is mis-managed, then a bigger set of rate hikes are required to get the same thing done.

In the medium term, RBI needs to build a team of top quality economists, who gain street cred by exuding knowledge of monetary economics. In the short term, the least that is required to be done is to stop the flow of low quality speeches.

Kicking the wheels of the new CPI

by Ashish Kumar.

Inflation measurement is a critical component of macroeconomic policy. In a recent paper, Patnaik et. al. have argued that while the CPI-IW has many problems, these difficulties are not first order, and that the CPI-IW can yield a reasonable measure of inflation today.

On 18 February 2011, CSO released a new CPI with base year 2010 (Jan-Dec =100). This new CPI has five important new features:

1. It is disaggregated at the rural and urban levels. The new overall all India CPI is a weighted average of the two. This is in contrast with the earlier CPIs which represented subsets of the population (industrial workers, agricultural labourers, rural labourers, etc.).
2. The new series has better geographical as well as commodity coverage. The basket of consumer goods has risen from 25 to 250.
3. The weights have been derived from the 61st round of the NSS consumer expenditure survey (2004-05).
4. Data for the urban CPI will be collected from 310 towns (compared to 78 in the current CPI-IW, for all India). The rural CPI will use data from 1181 villages. Field officers of the NSSO and the Department of Post will be the price collection agents for urban and rural centers respectively.
5. Since the two series are not comparable, year-on-year inflation numbers based on the new CPI will be available only from February 2012.

Sub Group		New CPI
	Rural	Urban	All India	CPI IW
Food, beverages and tobacco	59.31	37.15	49.71	50.20
Fuel and Light	10.42	8.40	9.49	6.25
Clothing, bedding and footwear	5.36	3.91	4.73	13.28
Housing	0.00	22.53	9.77	5.33
Miscellaneous	24.91	28.00	26.31	24.94

The share of food in the new CPI series has seen a small dip in comparison to the CPI-IW while the share of services has risen. The share of housing has also seen a sharp rise. In CPI-IW, the price of housing services was imputed from the house rent allowance given to civil servants. For the new CPI series, housing prices will be collected through surveys of a sample of rented dwellings in 310 towns.

The weights in the new CPI are taken from a household survey by NSSO. This is, however, already quite dated given that it was conducted in 2004-05. It is hence interesting to compare these weights with those seen in the CMIE Consumer Pyramids dataset, which goes upto the quarter ending Dec 2010. This is a panel dataset where 140,000 households are measured every quarter.

The household basket as shown by CMIE gives a weight to rent based on households that report rent. The CPI uses an imputed rent. An imputed rent calculation for the CMIE data is not feasible based on the information presently given out by CMIE. In order to render the two comparable, we purge both consumption baskets of rent.

Sub Group	New CPI, rural	CMIE: Oct-Dec 2010, rural
Date	2004-05	2010-11
Food, beverages and tobacco	59.31	59.57
Fuel and Light	10.42	12.12
Clothing, bedding and footwear	5.36	3.75
Miscellaneous	24.91	24.54

In rural India, the weights of food and miscellaneous in the new CPI match that seen in the CMIE consumer pyramids even though the CMIE dataset is much more timely. In comparison to the Consumer Pyramids weights, fuel and light is under-weighted while the clothing category is over-weighted in the new CPI. The fact that these differences are small gives us increased confidence in the NSSO and in the new CPI.

Sub Group	New CPI, urban	CMIE: Oct-Dec 2010, urban
survey in	2004-05	2010-11
Food, beverages and tobacco	47.96	45.95
Fuel and Light	10.84	16.45
Clothing, bedding and footwear	5.04	3.78
Miscellaneous	36.14	33.82

A similar comparison in urban India shows noticeable differences in all categories. The weights for the food group is lower in the CMIE data. Both the clothing and the miscellaneous categories exhibit similar patterns. The fuel group has a significantly higher weight in Consumer Pyramids. Over time, the role of fuel has risen.

Sub Group	New CPI, all India	CMIE: Oct-Dec 2010, all India
survey in	2004-05	2010-11
Food, beverages and tobacco	55.09	53.48
Fuel and Light	10.52	14.06
Clothing, bedding and footwear	5.24	3.77
Miscellaneous	29.16	28.69

All India weights reveal similar patterns as urban India weights. This is not surprising because all India figures are weighted averages of rural and urban weights.

Assuming NSSO did a good job of measurement in 2004-05, this suggests that over a short period of time, the expenditure pattern of Indian households has been changing at a fast pace.

Despite the issue of weights, the new CPI series is a welcome step. Improvements in inflation measurement will be an important component of the Indian process of refashioning monetary policy to deliver low and stable inflation,