Wednesday, March 24, 2010

Credit where it won't be due...

For those of you who read Paul Krugman's blog, it'll be obvious that I've borrowed the title from him. But it's as relevant here as there. Let me elaborate...

When the RBI hiked interest rates recently, it supposedly acted in response to a buildup of inflationary pressures in the economy. Whether higher interest rates provide a solution to current inflation or not is a matter for separate discussion, detailed in an earlier post, Inflation and the RBI.

What is more striking is the timing of the hike. No matter what projections one uses to forecast inflation, it is obvious that inflation has peaked. This is because of a phenomenon called base effect.

How it works is extremely simple. Inflation is measured every week for a 52 week period. This means that every week the 52 week period moves one week forward with the latest week being added and the oldest week removed. For example, when measuring inflation for the period ending March 19, 2010, the 52 week period starts March 21, 2009. After one week when measuring inflation for the period ended March 26, 2010, the 52 week period will start from March 28, 2009. Now suppose that inflation in the week of March 21-28, 2009 was higher than inflation in the week of March 19-26, 2010. Since, the former, which is a higher number will be left out of the calculation and the latter, which is a lower number will be included, Inflation will reduce.

What this also shows is that inflation coming down does not mean prices coming down. All it means is, the pace at which prices were rising has been reduced, but prices are still rising. It is only when inflation is negative that prices have can be said to have actually come down. And a negative inflation number in the Indian context is a rarity.

So what does all of this mean for inflation in coming days? Well, since prices were rising very rapidly in the period March to November last year, and the pace of increase has slowed this year, inflation in the period March - November 2010 is expected to be significantly lower than inflation in the period March - November 2009. This means that when inflation is calculated in December 2010, it will be much lower than that in December 2009. Using even the most pessimistic projections, it is forecast that inflation will be well below 6.00% by December 2010. In fact, if more realistic projections are used, inflation should be well below 5.00% by then.

So inflation will come down because of statistical reasons. It would have reduced even if no monetary policy action had been taken by the RBI. But guess what's going to happen in December 2010.

The RBI, the Prime Minister, the Finance Minister & the Chairman of the Planning Commission will all be claiming credit for reducing inflation through "proactive monetary policy and fiscal measures" which in reality have no role to play. They will pat each other, and themselves, on the back. I would also bet that a self serving statement on inflation will be a part of next year's budget speech.

Amazing, the lies our politicians and bureaucrats will tell us. But who's to stop them?

1 comment:

  1. Well said Rajiv. My take is that we are witnessing a slowing in food price inflation. However, thanks to successive governments failure to stimulate supply, we will have manufactured products and services inflation gallopping. RBI is dumb to think it can do anything. It is much like the rating agencies, acting after the event.