Manmohan Singh is a man of history today; but for a long time he was in the centre of economic policy making. When she was Prime Minister, Indira Gandhi had once told him to control inflation, for letting prices go out of control was the surest way of losing power. He could have done nothing then to control oil prices, which Arab countries raised steeply to punish industrial countries for supporting Israel; she lost power, though oil prices were a minor factor in her loss of popularity. But he had a much longer political life; a quarter century after her assassination, he himself became Prime Minister. He utterly ignored her advice; inflation soared under him to the highest level recorded in India’s history. Despite it, his party was reelected, and he became the longest-serving Prime Minister next only to Nehru. Inflation hardly mattered to him, for the income he got from the government was well protected by his fellow politicians. But it matters to us whose incomes are not indexed. So it is to be hoped that his political successors will reduce inflation.
They found three variables to have the strongest influence. One was the pressure of excess demand or supply, which they measured by the deviation of GDP from its trend. Another was the rate of depreciation of the Rupee against the dollar, which is the rate at which imports become costlier relatively to domestic products. Finally, they found that the anti-inflationary monetary policy that Raghuram Rajan introduced in the second quarter of 2014 coincided with a distinct fall in inflation. Droughts – rains below normal – also accelerated inflation, though their impact was lower than of the other three factors.
Their results for the period after the second quarter of 2014 were different. Almost half of the explanation was lagged inflation; that is, inflation led people to expect prices to rise, and their behaviour based on this expectation – hoarding, for example – was the most important contributor to inflation. A third of the fall in inflation was explained by Rajan’s monetary policy regime – his policy, announced in advance, that Reserve Bank’s interest rates, at which it lent to or borrowed from banks, would depend on inflation. And a fifth of the fall was explained by the fact that the government slowed down the rate at which it raised the prices at which it bought foodgrains from farmers.
The pressure of demand, which was so important in the long run, dropped out in the more recent period. This is probably because it varied much less in the recent period. The other difference was the entry of minimum support price of foodgrains. It is surprising that it did not enter the long-run equation. Chinoy’s explanation is that MSP is not picked out of the air. When the government decides to raise the MSP, it takes into account the rise in prices of other commodities, especially of those purchased by farmers. So a good deal of the impact of change in MSP is captured by the lagged inflation variables. If inflation is brought down, it will become less necessary to raise MSP.
So, the determinants of inflation are complex, and change quite quickly. It is a pity that Rajan will not be around to read the tea leaves. Let us see if the government finds someone as good.