Opinion Cut and haste

Should the decline in the WPI headline inflation number lead the monetary authority to cut interest rates? To answer that question, we need to understand how monetary policy impacts inflation. First, it has an impact through aggregate demand. Second, and equally importantly, it has an impact through inflationary expectations. Forward expectations of inflation play a role in determining today’s cost and pricing structure. If everyone expects inflation to come down, price and wage setting is such that everyone agrees to hold back in raising prices. Costs go up less and consequently there will be lower inflation. Though India does not have a good measure of inflationary expectations, it is not clear that people expect inflation to come down. Untimely rain and vegetable shortages may even push it up further. Thus, even if the monetary authority was concerned about WPI-based inflation, it would have to wait for a few months of low inflation until inflationary expectations came down.

However, consumers and hence monetary authorities do not really worry about the WPI, which is nobody’s consumption basket. The last few years have seen a divergence between the CPI and WPI, and this has made the WPI unsuitable as a target for inflation. Earlier, the WPI could be used for forecasting CPI inflation as the two moved together, though often the CPI was higher and more volatile due to a higher share of food. However, since the divergence, using the WPI has become unacceptable. As the Urjit Patel report recommended, the CPI must be the basis of the inflation rate that the RBI targets. In line with this, the report suggests that by January 2015, the CPI rate should be brought down to 8 per cent. If the CPI falls during the year, it would mean that the RBI will cut rates. The typical Taylor rule in a central bank reaction function also has a weight for the output gap. Thus, if output is forecasted to fall, and is thus likely to put a downward pressure on prices, the interest rate may be cut. At present, it is not clear that the decline in output is creating significant downward pressure on prices.

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Stagflation, which consists of falling output and high inflation, is always a very difficult problem to deal with. The answers are not obvious as they may be while the economy is overheating, when a rise in rates would cut demand and reduce prices. In stagflation, the main problem is seen to be high inflationary expectations. It is not obvious that the RBI believes that inflationary expectations are already down to desired levels. It should not cut rates in the upcoming policy unless this is the case.