In the first quarter review of monetary policy 2009-10, the Reserve Bank of India (RBI) maintained a GDP growth forecast of 6 per cent for 2009-10 which matches exactly with our projections (Economic Times, 2 July 2009). It raised the WPI inflation forecast to 5 per cent at the end of March 2010 from 4 per cent it did in April 2009. The RBI kept all policy rates (repo rate, reverse repo rate and cash reserve ratio) unchanged. The reason for a pause in monetary easing is that the central bank now considers inflation to be a cause of worry.  With WPI inflation in the negative territory from June 2009 onward, is the stance of the RBI justified?

In India, year-on-year change in wholesale price index (WPI) is used as the measure of inflation.  It has been pointed out that month-on-month changes captures the recent trends where as year-on-year changes capture the cumulated changes over a longer period. But month-on-month changes suffer from seasonality and, therefore, a deseasonlized price series would better represent the recent inflation. Chart 1 depicts the seasonally-adjusted month-on-month annualized percentage change of the WPI using what is called the “X-12” method. It shows that we had a deflationary phase during Ocober 2008–March 2009 which is over and we have inflation now hovering around just below 5 per cent.

Chart 1:  WPI Inflation
 (Month-on-month annualized % change)

The wholesale price index has long been discarded by countries for measuring inflation. The Economic Survey 2008-09 notes that 157 countries out of 181 countries in the IMF statistics use consumer price index (CPI) for tracking inflation. India does not have an aggregate CPI but computes sectional CPIs for the four different consumer categories (agricultural labour, rural labour, industrial worker and urban non-manual employee). Using all four CPIs we have constructed a composite CPI with the weights assigned based on the proportion of households in each employment category (NSSO Employment survey, 2004-05). Chart 2 plots month-on-month annualized percentage changes in the composite deseasonalized CPI. Chart 3 shows year-on-year percentage changes in the composite CPI.

Chart 2:  Composite CPI Inflation
 (Month-on-month annualized % change)

Chart 3:  Composite CPI Inflation
 (Year-on-year % change)

The month-to-month annualized seasonally-adjusted CPI (chart 2) indicates that we had a double digit inflation phase during February-September 2008 and inflation is remaining high at about 8 per cent in recent months. On a year-on-year basis, the CPI inflation remained at about 10 per cent since August 2008 (chart 3).

Of the two measures of CPI inflation, which one truly represents inflationary expectations in the economy?  Month-to-month inflation would represent the recent trends where as year-on-year would represent the long-term inflation. It is the long-term inflation which is the basis of inflationary expectations.

Another consideration for monetary policy is the level of real interest rate. If the real interest rate is high then there is a case for lowering policy rates by the central bank. The average prime lending rate (PLR) of banks adjusted for year-on-year CPI inflation is a good measure of the emerging real interest rate in the economy. Chart 4 gives the movements in real interest rate and it shows that the real interest rate has fallen from above 7.5 per cent in December 2007 to 2- 3 per cent in recent months.

Chart 4: Real Interest Rate (% per annum)

To sum up, inflation is high and the real interest rate low in the country. This justifies the RBI stance in keeping policy rates unchanged.