Ashima Goyal and Sanchit Arora of IGIDR reflect on India’s potential growth.
The paper looks at potential growth via aggregate supply function. It says India’s aggregate supply curve is elastic but subject to upward shocks. If the shocks lead to inflation in the second round, it indicates that growth is above potential. Given this empirical relationship it tests potential growth in 2007-08 and 2010-11 periods when there was upward supply shock to inflation. In first phase it seems growth had hit above potential. This is not the case in 2010-11 phase. Further, they hint that policy rates were tightened more than needed:
Estimates suggest that Indian aggregate supply is elastic but subject to upward shocks. If supply shocks make a high persistent contribution to inflation, it implies second round pass through is occurring, implying growth has reached its potential. This measure of potential growth draws on both theory and the structure of the Indian economy. It turns out supply shocks largely explain inflation. Output reached potential only in the years 2007-08 when growth rates exceeded 9 percent. In the period 2010-11 there was no sustained excess of growth over potential. Inflation was due to multiple supply shocks, rather than second round effects. Estimated linear and Markov switching policy rules suggest there was overcorrection in 2011.They show a two percent underestimate of potential output leads to a 50 basis point rise in policy rates.
Not convincing really. It assumes that the global environment is similar post-crisis as it was pre-crisis. Hence India’s so called potential growth rate remains the same in both the phases. Simple research shows Indian growth story was not unique in 2003-07 phase and was pretty much a global phenomenon. One could argue that Indian factors were diferent than others but lets face it. global situation was far more favorable then. And global situation is unlikrly to be similar as much of it was bubble which has been deflated with much of the deflation still happening.
As far as figuring whether inflation has led to second round effects or not, one can only sigh. The authors show second round impact is largely missing in 2010-11 phase. It seems inflation is everywhere but not getting measured by statistics and models!
The historical decomposition shows supply shocks account for a large share of inflation. Supply-shocks were countercyclical, that is they tended to reduce inflation during high growth periods such as 1995-96 and 2003-07. Adverse supply shocks tended to coincide with oil price spikes. The only period when supply shocks were sustained for a two-year stretch was 2007-08 showing growth had reached its then potential of 9 percent. Demand shocks did not contribute much to inflation except in 2006-07 and in 2010. Positive supply shocks and negative demand explain the combination of low growth and high inflation in 2008 and 2011. The supply shocks in this period included high international oil prices, the failure of rains in 2009, and fluctuating global risk which drove periodic rupee depreciation.
Part of the problem is imperfect measurement of inflation. WPI does not include services and many other things. CPI should be a better measure but we have very limited data for the same.
How about policy rates? They do a Taylor rule analysis and show:
In 2011-12 Q2 (September), when the policy rate was 8.25 and core inflation was about 10, equation (2) implied the policy rate should be 7.95 if the output gap was -1 and 8.15 if the output gap was +1. Instead the policy rate was raised to a peak of 8.5 in October. The rate of growth had fallen to 7 percent (with manufacturing at 2.7) so the output gap was probably larger than 1. Results are similar using headline inflation and equation (1). The equations estimate the RBI’s average behavior over the decade when the policy rate came to be actively used. It is possible the weight on inflation was higher when inflation was high, with some weight on output—since inflation targeting was never strict. To test if the weight on inflation rose in high inflation periods, we estimate a regime switching Taylor Rule.
Regime switching Taylor rule also shows similar results.
In 2011-12 Q2, when repo rate was 8.125percent (average of the quarter), inflation was about 9.35percent and exchange rate depreciation close to 2.35percent, equation (1) implied policy rate should have been 7.63 percent with output gap (+1) and 6.49 percent with output gap (-1) in 2011-12 Q3. Rather it was increased to a peak of 8.5 percent. In 2011there was overcorrection compared to past RBI behavior.
What accounts for this?
But underestimating potential growth can also explain some excessive monetary tightening. From the estimated TRs, a difference of two percent points in the estimated output gap would give about a 50 basis points difference in the policy rate. But even though growth falls in a slowdown, it does not necessarily imply potential growth has fallen 8.The Reserve Bank of India estimated potential growth at about 8 percent in 2011using non-inflationary past trend growth as a measure. Using filtered past trend growth would lower potential further to 7 percent, while the peak labour-financial resource based measure would range between7.5-9 percent. The supply shock based measure indicates output was below potential in 2011.
Well actually the issue is rather diferent. Instead of looking at potential growth via inflation we need to also see inflation via potential growth. If one argues India’s growth has edged lower, then inflation should also follow. However it has hardly fallen barirng the base effect. CPI inflation is in double digits . And we know food prices are the major factor for inflaiton expectations in India. Well, we can’t really do away with the fact that food still remain the highest % of consumption basket. If one says this is mainly because of supply show it should be the case in other emerging countries as where inflation has trended lower. Much of food inflaiton has become structural where people continue to consume despite higher bills. It actually shows we are not really capturing demand correctly..
In its Annual report-2011-12, RBI asks why inflation has not lowered despite growth falling off:
Nonetheless, the current high inflation phase is one of the longest phases of high inflation since the mid-1990s. Why inflation has been so persistent even in the wake of a growth slowdown has become an important issue for monetary policy. It may be noted that all three major drivers of inflation, viz., food, fuel and core have been significantly contributing to the high and persistent inflation. While food inflation has generally been volatile with large swings in the prices of certain food items like vegetables, the major driver of food inflation has been protein-rich items whose prices continue to grow at a faster pace. Both increased demand on account of structural changes in dietary patterns and rising input costs driven by increases in wages have contributed to the increase in protein inflation.
Since 1970s, there have been seven episodes of high and persistent inflation in India where the headline WPI inflation was above 8 per cent for more than six months on a sustained basis (Table II.2). Most of these episodes resulted in high inflation persisting for about 2-3 years. Even though these high inflation periods had different drivers like oil shocks, drought and currency devaluation, persistence of inflation seems to be a common pattern when inflation turns high.
It also asks Is Output Gap a Leading Indicator of Inflation?
Normalised impulse response functions of a bi-variate VAR model consisting of output gap and the WPI inflation rate (alternatively, headline and core) show that a one standard deviation shock to output gap results in an increase in both headline and core inflation, which reaches a maximum after three quarters and the impact wears off after 6-8 quarters or around 2 years.
Given that growth has slowed down significantly in the recent period, these results thus indicate that inflation, especially core, could moderate with a lag. However, the pace and extent of moderation could be conditional on other determinants of inflation such as supply shocks from food, global commodity price movements and exchange rate pass-through as well as the overall fiscal position. Currently most of these pressures persist, which partly explains the stickiness in inflation despite growth slowing down.
There is ar more spice to India growth-inflation nexus..There is plenty of noise in the debate and this post has also added to the noie