In Indian inflation is always and everywhere a rainy phenomenon

Take a look at this “Phillips” curve for India (its not really a real Phillips curve – as it is the relationship between annual real GDP growth and inflation):

Phiillips curve India Do you notice something?

Yes you are right – the slope of the Phillips curve is wrong. Normally one would expect that there was a positive relationship between real GDP growth and inflation, but for India the opposite seems to be the case. Higher inflation is associated with lower GDP growth.

The reason for this obviously is that supply shocks is the dominant factor behind variations in Indian inflation. That should not be a surprise as nearly 50% of the consumption basket is food.

Rain as a supply shock

A closer scrutiny of the Indian inflation data will actually show that the swings in Indian inflation primarily is a rainy phenomenon. Hence, the Indian monsoon and the amount of rainfall greatly influences the food prices and as a result short-term swings in inflation is primarily due to supply shocks in the form of more or less rainfall.

Obviously if the Reserve Bank of India (RBI) was following a strict ECB style inflation target then monetary policy would be strongly pro-cyclical in India as negative supply shocks would push up inflation and down real GDP growth and that would trigger a tightening of monetary policy. This would obviously be an insanely bad way of conducting monetary policy and the RBI luckily realises this.

The RBI therefore focuses on wholesale prices (WPI) rather than CPI in the conduct of monetary policy and that to some extent reduces the problem. The RBI further try to correct the inflation data for supply shocks to look at “core” measures of inflation where food and energy prices are excluded from the inflation data.

However, the problem with use “core” inflation that it is in no way given that changes in food prices is driven by supply factors – even though it often is. Hence, demand side inflation might very well push up domestic food prices as well. Hence, it is therefore very hard to adjust inflation data for supply shocks. That said it is pretty hard to say that the RBI has followed any consistent monetary policy target in recent years and inflation has clearly been drifting upwards – and food prices can likely not explain the uptrend in inflation.

On the other hand NGDP targeting provides the perfect adjustment for supply shocks  and it would therefore be much better for the RBI to implement an NGDP target rather than  a variation of inflation targeting. Unfortunately at the present the RBI don’t really officially target anything and monetary policy can hardly be said to be rule based. As I stressed in my earlier post on Indian monetary policy the RBI needs to move away from the present ad hoc’ism and introduce a rule based monetary policy.

PS Monetary policy is certainly not India’s only economic problem – and not even the most important economic problem. I my view India’s primary economic problem is excessive interventionism in the economy, which greatly reduces the growth potential of the economy.

PPS see also this fairly new IMF Working Paper on monetary policy rules. The conclusions are quite supportive of NGDP targeting.

PPPS The link between rain, inflation and monetary policy in India is being complicated further by the fiscal response in the form of food and agricultural subsidies in India, but that is a very long story to tell…

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Argentina’s hidden inflation – another case of the horrors of price controls

In my previous post I discussed how price controls likely have created a wedge between inflation measured by CPI and by the GDP deflator in Malaysia. That made me think – can we find other examples of this in the world? And sure thing the story of Argentina’s inflation over the last decade seem to be more or less the same thing.

The graph below shows Argentine inflation measured by CPI and the GDP deflator since 2002. The difference is very easy to spot.

It is very clear that until 2005 the two measures of inflation tracks each other quite closely, but from 2005 a difference opens up. So what happened in 2005? Well, the story is exactly as in Malaysia – monetary policy is inflationary and the government tries to curb inflation not by printing less money, but by introducing price controls.

Here is a story from Bloomberg November 24 2005:

Argentine President Nestor Kirchner accused supermarkets of price fixing and said he would increase controls to slow a surge in inflation.

Kirchner, in a televised speech at the presidential palace, said agreements between supermarkets such as Coto CISA SA and Hipermercados Jumbo SA, a unit of Chilean retailer Cencosud SA, to increase prices would lead to 12 percent inflation next year. In the 12 months through October Argentina’s consumer prices rose 10.7 percent, the fastest rate of increase in 29 months.

“We will fight to defend consumers’ pockets,” Kirchner said, without specifying how he would slow price increases.

The accusation underscores the government’s concern over quickening inflation, which may increase poverty in a country where almost 50 percent of the population cannot afford to cover their food and other basic needs, said economist Rafael Ber of Argentine Research brokers in Buenos Aires.

Rising prices may also hurt the ability of Argentine producers to compete with foreign goods, Ber said.

Kirchner has already attacked private companies for increasing prices. In April, he called on consumers to boycott The Royal Dutch Shell Group after the energy company increased prices.

So there you go – price controls in response to inflation. That is never good news and the result has been the same in Argentina as in Malaysia (actually it is much worse) – shortages (See also my previous discussion of food shortages in Venezuela and Argentina here).

Price controls always have the same impact – shortages – and if you think Malaysia and Argentina are the only countries in the world to make this kind of policy mistakes think again. Here is from the US, where a Republican governor these days is experimenting with price controls and the result is the same as in Argentina and Malaysia – shortages!

PS it should be noted that the Argentine inflation data very likely is manipulated so there is more to it than just price controls – we also has a case of the books being cooked. See more on that here.

Guest post: Yes Lars, inflation is always and everywhere a monetary phenomenon (By Jens Pedersen)

Guest post: Yes Lars, inflation is always and everywhere a monetary phenomenon
By Jens Pedersen

The host of this blog, my good friend and colleague, on a daily basis reminds me “inflation is always and everywhere a monetary phenomenon” – and even more so this week where we have celebrated Milton Friedman’s birthday. I certainly do not need any convincing. On the contrary with this blog post I will present evidence that this is has indeed also been the case during the “The Great Recession”.

Following the general New Keynesian Phillips curve formulation current inflation depends on the expected future inflation and the gap between current output and the natural level of output. If a larger share of prices is adjusted every period then current inflation will depend more strongly on the current output gap and vice versa.

Using the New Keynesian framework it is possible to show that monetary policy during “The Great Recession” has had leverage over the development of prices both in the short run and the long run. Atlanta Fed’s monthly sticky price index will serve helpful in this. The sticky price index basically comprises the price components in the US consumer price index that are adjusted infrequently. Atlanta Fed furthermore publishes a flexible counterpart comprising the components in the US consumer price index that are adjusted frequently.

The first chart below depicts the development in US flexible core price inflation since 2008. I have used the three-month annual inflation rate only to get a smoother trend – it does not affect the main points of the analysis. I have marked seven turning points in the flexible core inflation that coincides with significant monetary policy shocks. 1) ECB surprises with a 0.25 %-point increase in interest rates, 2) Fed launches first round of QE, signals extended period of low rates, other major central bank cuts rates, Fed open dollar swap line, 3) Fed ends dollar swap line, 4) Bernanke mentions QE2, Fed launches QE2, 5) Trichet signals “strong vigilance”, ECB raises the interest rate twice, 6) ECB implements 3 year LTRO, 7) ECB tightens collateral rules.

What this brief analysis shows is that frequently adjusted prices do react to changes in monetary policy. When monetary policy is eased, demand increases and subsequently prices increase and vice versa.

In contrast, sticky price inflation does not only reflect the reaction to current monetary policy shocks, but also the expectations of the future development in demand. If demand is expected to increase then the sticky price inflation will increase as well.

The second chart below illustrates US sticky core price inflation since 2008. What the sticky core price inflation chart shows is that the monetary policy shocks in the end of 2008 (QE1 and extended period language) briefly improved the outlook for the US economy, but it was not before Fed launched QE2 in the second half of 2010 that sticky core inflation started increasing reflecting expectations of increasing demand. The chart further shows that sticky core inflation has started declining since the end of 2011. Hence, recently monetary policy has not done enough to maintain expectations of increasing demand.

The above analysis shows that consumer prices do contain substantial information on the effects of monetary policy. And to sum up, yes Lars, you are certainly right – inflation is always and everywhere a monetary phenomenon!

PS The Flexible and sticky prices series come from Federal Reserve Bank of Atlanta’s Inflation Project.

The spike in Kenyan inflation and why it might offer a (partial) solution to the euro crisis

The euro zone is suffering from deflationary pressures and there is an obvious a need for monetary easing. On the other hand Kenya do not have that problem. In fact Kenyan inflation (and NGDP) has risen sharply since 2009. In some sense you can say that Kenya has what the euro zone needs and it is therefor interesting to examen why Kenya inflation has risen in recent years. I should of course stress that I don’t think the the euro zone need Kenyan monetary policy, but monetary developments in Kenya in recent years might nonetheless tell us how we could get monetary easing in countries like Greece and Spain – even if the ECB maintains it’s “do-nothing” stance (in fact the ECB is passively tightening monetary policy on a daily basis these days).

There are a number of reasons for the increase in inflation in Kenya, but notable reason undoubtedly is the increase in money-velocity since 2010. The increase in money-velocity to the financial innovation called M-pesa. M-pesa is a mobile based payment system operated by the mobile telephone provider Safaricom.

See here from African Development Bank (ADB) report on East African inflation from 2011:

“In the case of Kenya, the advent of financial innovation such as e-money may have contributed to the increase in velocity of money as seen by the corresponding rise in the number of M-PESA subscribers (Figure 8). The M-PESA has brought more than 14 million customers into virtual banking. According to the IMF (IMF, 2011), M-PESA processes more transactions domestically within Kenya than Western Union does globally. The M-PESA platform also provides mobile banking facilities to more than 70 percent of the country’s adult population. Evidence shows that the transactions velocity of M-PESA may be three to four times higher than the transactions velocity of other components of money.

The increase in the velocity of money induced by these activities may have in turn propagated self-fulfilling inflation expectations and complicate monetary policy implimentation. The monetary authorities may inadvertently follow looser monetary policy if the stock of e-money grows more rapidly than projected.

Further, since effective monetary policy is anchored on a constant money demand function, under conditions of unstable money, rising velocity and deep supply shocks, monetary policy based on interest rate targeting has a limited impact in controlling inflation.”

This of course is an argument why the Kenyan central bank should stop operating a “monetary policy based on interest rate targeting”, but it also shows that if the central bank operationally targets the interest rate (this is what both the Federal Reserve and the ECB do) then a positive or negative shock to velocity will impact nominal GDP and inflation.

And this also provides a partial solution to the euro crisis. Imagine if M-Pesa was introduced in Spain and/or Greece and had the same impact on money-velocity as in Kenya then that would obviously increase Greek and Spanish nominal GDP even if the money supply is kept unchanged.  That would seriously reduce the pressure on public finances and improve the general macroeconomic environment by reducing deflationary pressures.

Obviously this would not work if the ECB would counteract the increase in money-velocity by reducing money supply and given the track record of the ECB that can unfortunately not be ruled out (remember that few other central banks would have hiked interested under the circumstances the ECB hiked last year). That said, a sharp increase in Greek and Spanish money-velocity would certainly do no harm at the the moment. In fact it is badly needed.

So is this in anyway realistic? Well, I doubt the introduction of a M-Pesa style system would in anyway be enough to solve the euro zone crisis. Furthermore, it should be noted that M-Pesa has not in general been regulated within the framework of the regular Kenyan banking regulation and this is clearly part of the reason for the success of the scheme. I doubt that any European central bank would have a similar open-minded view of e-money as the Kenyan central bank. However, that does not change the conclusion that technological development and a liberalization of banking legislation in the crisis hit European economies could give an badly needed boost to money-velocity – and the ECB would not have to buy one-single Spanish government bond to achieve it. Just allow M-Pesa mobile banking and you can at least make some sort of monetary easing more likely.

PS the clever reader might realize that this is a very moderate Free Banking style proposal to reduce monetary disequilibrium in the euro zone.

US Monetary History – The QRPI perspective: The Volcker disinflation

I am continuing my mini-series on modern US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I will have a look at the early 1980s and what have been termed the Volcker disinflation.

When Paul Volcker became Federal Reserve chairman in August 1979 US inflation was on the way to 10% and the fight against inflation had more or less been given up and there was certainly no consensus even among economists that inflation was a monetary phenomenon. Volcker set out to defeat inflation. Volcker is widely credited with achieving this goal and even though one can question US monetary policy in a number of ways in the period that Volcker was Fed chairman there is no doubt in mind my that Volcker succeed and by doing so laid the foundation for the great stability of the Great Moderation that followed from the mid-80s and lasted until 2008.

Below you see my decomposition of US inflation in the 1980s between demand inflation (which the central bank controls) and supply inflation.

As the graph shows – and as I spelled out in my earlier post on the 1970s inflationary outburst – the main cause of the rise in US inflation in 1970s was excessive loose monetary policy. This was particularly the case in late 1970s and when Volcker became Fed chairman demand inflation was well above 10%.

Volcker early on set out to reduce inflation by implementing (quasi) money supply targeting. It is obviously that the Volcker’s Fed had some operational problems with this strategy and it effectively (unfairly?) undermined the idea of a monetary policy based on Friedman style money supply targeting, but it nonetheless clearly was what brought inflation down.

The first year of Volcker’s tenure undoubtedly was extremely challenging and Volcker hardly can say to have been lucky with the timing. More or less as he became Fed chairman the second oil crisis hit and oil prices spiked dramatically in the wake of the Iranian revolution in 1979. The spike in oil prices boosted supply inflation dramatically and that pushed headline inflation well above 10% – hardly a good start point for Volcker.

Quasi-Real Price Index and the decomposition of the inflation data seem very clearly to illustrate all the key factors in the Volcker disinflation:

1)   Initially Volker dictated disinflation by introducing money supply targeting. The impact on demand inflation seems to have been nearly immediate. As the graph shows demand inflation dropped sharply in1980 and the only reason headline inflation did not decrease was the sharp rise in oil prices that pushed up supply inflation.

2)   The significant monetary tightening sent the US economy into recession in 1980 and this lead Volcker & Co. to abandon the policy of monetary tightening and “re-eased” monetary policy in the summer of 1980. Again the impact seems to have been immediate – demand inflation picked up sharply going into 1981.

3)   Over the summer the Fed moved to hike interest rates dramatically and slow money supply growth sharply. That caused demand inflation to ease off significantly and inflation had finally been beaten.

4)   The Fed allowed demand inflation to pick up once again in 1984-85, but at that time Volcker was more lucky as supply factors helped curb headline inflation.

The zigzagging in monetary policy in the early 1980s is clearly captured by my decomposition of inflation. To me shows how relatively useful these measures are and I think they could be help tools for both analysts and central bankers.

This post in no way is a full account of the Volcker disinflation. Rather it is meant as an illustration of the Quasi-Real Price Index and my suggested decomposition of inflation.

My two main sources on modern US monetary history is Robert Hetzel’s “The Monetary Policy and the Federal Reserve – A History” and Allan Meltzer’s “A History of the Federal Reserve”. However, for a critical account of the first years of the Volcker disinflation I can clearly recommend our friend David Glasner’s “Free Banking and Monetary Reform”. I am significantly less critical about money supply targeting than David, but I think his account of the Volcker disinflation clear give some insight to the problems of money supply targeting.

US Monetary History – The QRPI perspective: 1960s

In my previous post I showed how US inflation can be decomposed between demand inflation and supply inflation by using what I term an Quasi-Real Price Index (QRPI). In the coming posts I will have a look at use US monetary history through the lens of QRPI. We start with the 1960s.

In monetary terms the 1960s in some sense was a relatively “boring” decade in the sense that inflation remained low and relatively stable and growth – real and nominal – was high and relatively stable. However, the monetary policies in the US during this period laid the “foundation” for the high inflation of the 1970s.

In the first half of the 1960s inflation remained quite subdued at not much more than 1%, however, towards the end of the decade inflation started to take off.

What is remarkable about the 1960s is the quite strong growth in productivity that kept inflation in check. The high growth in productivity “allowed” for easier monetary policy than would otherwise have been the case an demand inflation accelerated all through the 1960s and towards the end of the decade demand inflation was running at 5-6% and as productivity growth eased off in 1966-67 headline inflation started to inch up.

In fact demand inflation was nearly as high in the later part of the 1960s in the US as was the case in the otherwise inflationary 1970s. In that sense it can said that the “Great Inflation” really started in 1960 rather than in the 1970s.

My favourite source on US monetary history after the second War World is Allan Meltzer’s excellent book(s) “A History of the Federal Reserve”. However, Robert Hetzel’s – somewhat shorter – book “The Monetary Policy of the Federal Reserve: A History” also is very good.

Both Meltzer and Hetzel note a number of key elements that were decisive for the conduct of monetary policy in the US in the 1960s. A striking feature during the 1960s was to what extent the Federal Reserve was very direct political pressure by especially the Kennedy and Johnson administrations on the Fed to ease monetary policy. Another feature was the most Federal Reserve officials did not share Milton Friedman’s dictum that inflation is a monetary phenomenon rather the Fed thinking was strongly Keynesian and so was the thinking of the President’s Council of Economic Advisors. As a consequence the Federal Reserve seemed to have ignored the rising inflationary pressures due to demand inflation and as such is fully to blame for the high headline inflation in the 1970. I will address that in my next post on US monetary history from an QRPI perspective.

Sumner, Glasner, Machlup and the definition of inflation

David Glasner has a humorous comment on Scott Sumner’s attempt to “ban” the word “inflation”.

Here is Scott:

“Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices.  Yes, there are some types of inflation that hurt consumers.  And yes, there are some types of inflation created by Fed policy.  But in a Venn diagram those two types of inflation have no overlap.”

While David partly agrees with Scott he is not really happy giving up the word “inflation”:

“So Scott thinks that if only we could get people to stop talking about inflation, they would start thinking more clearly. Well, maybe yes, maybe no…At any rate, if we are no longer allowed to speak about inflation, that is going to make my life a lot more complicated, because I have been trying to explain to people almost since I started this blog started four months ago why the stock market loves inflation and have repeated myself again and again and again and again.”

The discussion between these two light towers of monetary theory reminded me of something I once read:

“When I began studying economics at the University of Vienna, immediately after the First World War, we were having a rapid increase of prices in Austria and, when asked what the cause was, we said it was inflation: By inflation we meant the increase in that thing which many are now afraid to mention – the quantity of money” (Fritz Machlup 1972)

But hold on for a second Fritz! That’s wrong! Lets have a look at the equation of exchange (in growth rates):

m+v=p+y

If the rate of growth in the quantity of money (m) equals inflation then inflation must be defined as p+y-v. And then if we assume (rightly a wrongly) that v is zero then it follows that inflation is defined as p+y.

What is p+y? Well that is the growth rate of nominal GDP! Hence, using the Machlup’s definition of inflation as the growth of the quantity of money then inflation is in fact nominal GDP growth.

So maybe David and Scott should not disagree on whether to ban the word “inflation” – maybe they just need to re-state inflation as the velocity adjusted growth of the quantity of money also known as NGDP growth.

PS this definition of inflation would also make David’s insistence that the stock market loves inflation a lot more reasonable.

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