RBI raised rates, saying that they are concerned about inflation. What is the state of inflation in India? I find it useful to look at an approximate `core WPI’ that is obtained by removing food and fuel from the overall WPI. This has to be done carefully because some food is present in WPI Manufacturing.
The right way to think about inflation is to not compute the year-on-year change in prices — this shows the average inflation over the last 12 months. The right path is to compute month-on-month changes. This requires care about seasonality. These results are taken from the http://www.mayin.org/cycle.in website:
| Month | Point-on-point change (annualised) |
| 2009 Sep | 1.61 |
| 2009 Oct | -0.11 |
| 2009 Nov | 9.67 |
| 2009 Dec | 5.12 |
| 2010 Jan | 9.33 |
| 2010 Feb | 2.93 |
| 2010 Mar | 27.49 |
| 2010 Apr | -4.07 |
| 2010 May | 34.86 |
In September and October 2009, inflation was at sub-target levels: this was a time to cut rates. After that, inflation has reared up again. In particular, the rise in prices in March when compared with February was 27.49% (annualised). And in the most recent data, the rise in prices in May when compared with April was 34.86% (annualised). In other words, if prices rose for a year the way they rose from April to May, this would yield 34.86% YOY inflation within 11 months.
We find it useful to smooth this using the three-month moving average:
It makes sense for RBI to raise rates under these conditions.
Will it help matters?
Only a little.
In a well functioning market economy, small changes in the short rate by the central bank propagate all across the economy, into myriad asset prices, through the `monetary policy transmission’. In India, given the malfunctioning Bond-Currency-Derivatives Nexus and the lack of competition in banking, very little happens in the economy by way of reduced aggregate demand when RBI raises rates.
One feeble channel which works is : when local interest rates are higher, more money comes into India, which gives a stronger rupee, which helps control inflation. This effect is also weakened owing to capital controls which interfere with such adjustments.
In short, RBI was right to raise rates; inflation is a serious problem; but RBI is mostly ineffectual in fighting inflation given the weakness of the financial system and thus the monetary policy transmission.
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