Archive for October 29th, 2007

Monetary and Macro developments- Mid-term review(2007-08)

October 29, 2007

RBI has released its report on developments in Indian economy and financial markets so far i.e. for Mid-term 2007-08. A neat summary of the events is given in RBI’s press release as well. RBI releases this report a day before its monetary policy meeting (whgich is to be held tomorrow Oct 30, 2007).

The report is a summary of developments and economic data releases and most of these are widely covered in media e.g. IIP, BoP, growth in GDP etc. However, in areas like agriculture, public finances etc the report is pretty useful.

On a quick glance, it seems rainfall this year has been above average and as a result kharif crop (on aggregate level) has been better.

On fiscal front, the situation looks grim as both fiscal and revenue deficit are higher.

I would post more as I read the entire report along with RBI’s monetary policy review to be released tomorrow.


Core Inflation vs Headline Inflation

October 29, 2007

I am just trying to catch up with times after the long vacation. I just read this excellent speechfrom Mishkin where he discusses which inflation measure is better in monetary policy- headline or core?

For the uninitiated, Headline inflation is your general index like WPI (for India), CPI etc. that includes all the items used for measuring inflation. Core inflation index excludes a certain items whose prices are more volatile and hence may not represent a true picture of the inflation.

Most countries have their own baskets of goods and services on the basis of which they make an index and inflation is tracked.  But, the excluded items from core inflation are mostly fuel and food items. As both are quite important items for consumers (households) should they be excluded? Or in other words do we need to at all follow core inflation?

Mishkin says yes, despite the problems it makes more sense for a central banker to follow core inflation than headline inflation.

 When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump.  Temporary supply shocks such as these raise the prices of food and energy relative to other prices and can have substantial effects on inflation in the short run.  By including all items–including particularly volatile items like food and energy–headline measures of inflation are inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and that monetary policy can affect.

Research has shown that headline inflation tends to revert strongly towards core inflation over a time period making the case for core stronger.  

Thus, as long as the permanent change in relative energy prices does not lead to a change in the underlying trend rate of inflation–a crucial assumption–then headline inflation will come back down again.  This is what we seem to have seen recently in the United States.  From a low near $30 per barrel in late 2003, the price of oil rose to $70 per barrel by the middle of 2006, and it has stayed high, with the current price more than $80.  That move increased headline PCE inflation to the 4 percent level for a time, but it has since retreated to around 2 percent

However, it is important to distinguish between temporary and permanent changes in prices. Temporary changes would reverse and do not warrant attention but permanent changes especially in the case of oil prices is important.

He goes on to show how economy would look if Fed responds to a oil shock by looking at both headline and core inflation.

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected . 

Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes. 

More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. 

Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate–variability that is much more subdued when policy responds to core inflation

Then he discusses various ways to measure core inflation and why central bankers need to also look at headline inflation. He stresses that Central Banks should clearly communicate their strategy to fight inflation which would lower inflationary expectations in the economy.

Excellent speech from Mishkin. Go through the rich reference list as well.

Assorted Links

October 29, 2007

I am back to work after a long break and hope blogging would be more regular now. Let me begin with putting some useful links/readings together of other bloggers.

1. Ajay Shah hasput together number of articles on India’s mon pol and capital controls. He pointsto an interesting analysis of India’s government bond market. The analysis is good but it just points to one side of the story. I think NDS system has improved transparency in the market by a great deal.

There is an interesting articleby Ila Patnaik on IIP data in India.

2. JR Varma has a nice take on Northern Rock episode.

3. TTR on service quality in London ( I am surprised by this), points to an interesting article by Taleb who takes a swipe at risk management techniques.

4. MR on sovereign wealth funds, pointsto a paper on subprime crisis

5. WSJ Blog points to an interview with Bill Poole, points to 31 Oct being an exciting day for Economists, points to economists reaction to Chinese economy growing by 11.5% in Q3.

6. Mankiw points to correlation vs causation, points to an excellent graph showing taxes as a % of GDp in different countries.

7. Rodrik on football on globalisation.

8. Fin Prof asks do finance profs practice what they preach?

9. Fin Rounds points to alumni networks matter More so in wall street firms.

10. EPSA Blog on reality of Indian primary education.

11. James Hamilton on why oil prices are rising? He also has a post on whether rising oil prices would lead to a recession or not?

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