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.