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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  1. A friend of mine is from India and still has deep family ties there. She went back visiting for a few weeks in December and she remarked about the frequent power outages, with one of them occurring as she at a theater watching a play. The stories about her visit reminded me not to take so much for granted when annoyed by the small frustrations in life.

  2. Rajat

     /  January 24, 2013

    Thanks Lars. I’m of Indian background and it is great to see some analysis of India’s macroeconomy.

    • Rajat, you are very welcome. India is an interesting country, but given the closed nature of the economy there is little global interest in the country – at least among private sector economists. That is too bad. I hope I have helped a little with these posts to spur some interest in the country.

  3. athreya74

     /  January 24, 2013

    Lars the main issue with India as you pointed out n the footnote is the excessive interventionism in real and financial sectors. Which has made Indian economy inflexible and financial sector a poor allocator of resources. These problems are swept under the carpet when global economy booms. However when global outlook is mixed like at present, Indian policymakers are forced to confront stark realities. In a sense, such crises are the only opportunities for reforms to move forward in India. The central bank has done an average job under the circumstances but India also suffers from poor calibre of economists. A rational response would be entice some economists from abroad to come and work in policy making positions. Sadly we in India have not gone down that route. One ray of hope though. Raghuram Rajan, formerly of IMF and Chicago Booth School is presently adviser to the Finance Ministry. I think he is a front runner to become the next RBI Governor. I am sure he will be sympathetic to your point about rules based monetary policy.

    • Athreya,

      I agree – unfortunately the tradition among the Indian civil service is rather interventionist and some outside influence would clearly do the country good when it comes to economic policy.

      I agree that Raghuram Rajan is a very capable economist and likely would make a good RBI governor. That said, I strongly disagree with some of his views on monetary policy as he seem to think that monetary policy in the US is impotent. I on the other hand think that monetary policy is highly potent. We do, however, agree that monetary policy (and fiscal policy for that matter) should be conducted within a rule based framework.

      And again – I think Indian potential growth is probably not more than 4-5%. That is far to low given the relatively low level of GDP/capita in India. India could easy be from 6-8% if the right economic reforms where implemented. There in my view is a massive need for opening the economy open and scrapping red-tape. The Indian economy remains massively over-regulated.

  4. Pacemaker

     /  January 31, 2013

    I may be commenting quite late, but Ritwik ( has a couple of posts on India’s macroeconomy. He says that Nominal GDP at factor cost has been quite stable for the past 6 years.

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