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DAILY NEWS ANALYSIS

  • 14 September, 2021

  • 20 Min Read

Monetary Policy Committee and Inflation in India

What is Inflation?

  • Inflation can be defined as a calculated surge in the average prices of goods and services for a longer duration in the economy.
  • It is a macro concept, wherein the effect of inflation is seen over a large basket of goods.
  • The ultimate effect of inflation is that the value of money is reduced i.e., the purchasing power of money is reduced.

Types of Inflation

1) Cost Push Inflation

  • It is caused by rise in the prices of inputs like raw material cost, electricity charges or wage rate (including a rise in profit margin made by the producer).
  • Ex. Price rise of coal/ crude oil may cause price rise in industries which use coal.
  • In India, cost push inflation is the major supply side factor producing inflation.
  • It can't be managed by monetary policy intervention by RBI. We have to augment production of commodities or imports. Other conventional measures are providing incentives like subsidies, tax cuts, and launching production boosting programmes like NFSM.
  • Other reasons:
  1. Increase in price of inputs
  2. Hoarding and Speculation of commodities
  3. Defective Supply chain
  4. Increase in indirect taxes
  5. Depreciation of Currency
  6. Crude oil price fluctuation
  7. Defective food supply chain
  8. Low growth of Agricultural sector
  9. Food Inflation (growth agriculture sector has been averaging at 3.5%

2) Demand Pull Inflation

  1. It is caused by increased demand or income in the economy (due to increased money supply), without adequate increase in supply of output.
  2. Ex. “too much money chasing too few goods” is an instance of demand pull inflation.
  3. Monetary Policy is the best way to tackle demand pull inflation. Increase in Repo rate will decrease demand for loans. Additional taxation by the Govt and reduced public expenditure are also good to reduce demand.
  4. This type of inflation is caused due to an increase in aggregate demand in the economy. Other reasons are:
    • A growing economy or increase in the supply of money – When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
    • Asset inflation or Increase in Forex reserves- A sudden rise in exports forces a depreciation of the currencies involved.
    • Government spending or Deficit financing by the government – When the government spends more freely, prices go up.
    • Due to fiscal stimulus
    • Increased borrowing
    • Depreciation of rupee

Other Types of Inflation

  1. Disinflation: Reduction in the rate of inflation
  2. Deflation: Persistent decrease in price level (negative inflation)
  3. Reflation: Price level increases when economy recovers from recession Based on value of inflation
  4. Creeping inflation – If rate of inflation is low (upto 3%)
  5. Walking/Trotting inflation – Rate of inflation is moderate (3-7%)
  6. Running/Galloping inflation – Rate of inflation is high (>10%)
  7. Runaway/Hyper Inflation – Rate of inflation is extreme
  8. Stagflation: Inflation + Recession (Unemployment)
  9. Suppressed / Repressed inflation: Aggregate demand > Aggregate supply. Here govt will not allow rising of prices.
  10. Open inflation: Situation where price level rises without any price control measures by the government.
  11. Core inflation: Based on those items whose prices are non-volatile.
  12. Headline inflation: All commodities are covered in this.
  13. Structural inflation: Due to structural problems like infrastructural bottlenecks.

Stagflation:

  • Stagflation is a situation where an economy faces both high inflation and low growth (and high unemployment).
  • The root cause for Stagflation is attributed to a drastic fall in consumer demand and it is possible because of the supply side issues.
  • Retail Inflation: Highest in Vegetable > Pulses and Products > Meat and Fish > Egg.
  • “Phillips Curve”: there is an inverse relationship between inflation and unemployment. Hence policy makers are advised to maintain a certain inflation rate to ensure that unemployment is kept to a minimum and the economy is operating at full capacity.

What causes Inflation?

  • Inflation is mainly caused either by demand Pull factors or Cost Push factors. Apart from demand and supply factors, Inflation sometimes is also caused by structural bottlenecks and policies of the government and the central banks.
  • Therefore, the major causes of Inflation are:
  • Demand Pull Factors (when Aggregate Demand exceeds Aggregate Supply at Full employment level).
  • Cost Push Factors (when Aggregate supply increases due to increase in the cost of production while Aggregate demand remains the same).
  • Structural Bottlenecks (Agriculture Prices fluctuations, Weak Infrastructure etc.)
  • Monetary Policy Intervention by the Central Banks.
  • Expansionary Fiscal Policy by the Government.

How to measure Inflation?

1) Consumer Price Index (CPI)

  • It is a measure of change in retail prices only of goods and services. It is calculated on a monthly basis.
  • It is used as an indicator of inflation, a tool for monitoring price stability and as a deflator in national accounts.
  • The Dearness allowance of Govt employees and wage contracts between labour and employer is based on CPI.
  • CPI is calculated by Laspeyre's index = [Total cost of a fixed basket of goods and services in the current period * 100] divided by Total cost of the same basket in the base period.
  • CPI consists of services like housing, education, medical care, recreation etc.
  • Presently the CPIs are:
  1. CPI (IW): Industrial workers; CPI (AL): Agricultural Labourers and; CPI (RL): Rural Labourers. They are occupation specific and compiled by Labour Bureau.
  2. CPI (Urban); CPI(Rural) and CPI (Combined): Have wider coverage and are compiled by CSO (now NSO). CPI for Urban Non Manual Employees was earlier computed by CSO but discontinued since 2008.
  • RBI uses CPI-combined as the sole inflation measure for monetary policy.
  • Price data are collected from selected towns by the Field Operations Division of NSSO and from selected villages by the Department of Posts.
  • NREGA wages are currently linked with CPI (Agriculture Labour) but now Government has decided to index it to a new CPI (Rural).
  1. CPI (R) is wider and covers more non food items like Insurance, Health and Education. CPI (AL) includes more food items.
  2. Hence CPI (R) reflects better rural consumption basket compared to CPI (AL).
  3. A living wage should include health, education and insurance besides base essentials.

Wholesale Price Index (WPI)

  • It is aka Point to Point Inflation.
  • WPI measures the average change in the prices of only goods (not services) at wholesale level. Base year 2011 - 12. 697 goods.
  • Components and Prices tracked are:
  1. Manufactured products (64%): Ex factory price.
  2. Primary Articles (23%): Mandi price for Agri commodities.
  3. Fuel and Power (13%): Ex mines price for minerals.
  • Calculated by Office of Economic Advisor (OEA), DPIIT, Ministry of Commerce
  • The main uses of WPI are the following:
    1. Check Inflation.
    2. It is used as a deflator for many sectors including GDP by CSO.
    3. WPI is also used for indexation by users in business contracts.
    4. Global investors also track WPI as one of the key macro indicators for their investment decisions.
    5. It includes manufacturing inputs and intermediate goods.
  • Revision of Base Year to 2011 - 12 in 2017
    1. It is a regular exercise to capture structural changes in the economy and improve the quality and coverage of index.
    2. In 2017, the Base year was revised (7th time) from 2004 - 05 to 2011 - 12 (based on Dr. Saumitra Chaudhuri Committee) to align it with other macroeconomic indicators like GDP and IIP.
    3. It also changed the basket of commodities and assigned new weights to the commodities.
    4. WPI with Base year 2011 - 12 doesn't include taxes to remove the impact of fiscal policy.
    5. Now, WPI series is closer to Producer Price Index which reflects the change in average prices of goods & services either as they leave or enter the production process. It measures changes in the prices that producers get.

What is the difference between WPI & CPI?

  1. WPI, tracks inflation at the producer level and CPI captures changes in prices levels at the consumer level.
  2. Both baskets measure inflationary trends (the movement of price signals) within the broader economy, the two indices differ in which weightages are assigned to food, fuel and manufactured items.
  3. WPI does not capture changes in the prices of services, which CPI does.

Headline Retail Inflation vs Core Inflation

  • Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released by CSO. The headline figure is not adjusted for seasonality or for the often-volatile elements
  • Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month, which can cause unwanted distortion to the headline figure. The most commonly removed factors are those relating to the cost of food and energy.

Urjit Patel Committee on Monetary Policy Committee

  • The expert committee was headed by Urjit R. Patel, Deputy Governor of the Reserve Bank of India.
  • The committee felt that inflation should be the nominal anchor for the monetary policy framework. The nominal anchor or the target for inflation should be set at 4 per cent with a band of +/- 2 per cent around it.
  • “It should be set by the RBI as its predominant objective of monetary policy in its policy statements,’’ the report said.
  • The nominal anchor should be communicated without ambiguity, so as to ensure a monetary policy regime shift away from the current approach to one that is centred around the nominal anchor.
  • “The nominal anchor should be defined in terms of headline CPI inflation, which closely reflects the cost of living and influences inflation expectations relative to other available metrics,’’ the committee felt.
  • “This target should be set in the frame of a two-year horizon that is consistent with the need to balance the output costs of disinflation against the speed of entrenchment of credibility in policy commitment,’’ the report said.
  • Since food and fuel account for more than 57 per cent of the CPI on which the direct influence of monetary policy is limited, the commitment to the nominal anchor would need to be demonstrated by timely monetary policy response to risks from second-round effects and inflation expectations in response to shocks to food and fuel, the committee pointed out.
  • The committee asked the Central Government to ensure that the fiscal deficit as a ratio to GDP (gross domestic product) is brought down to 3.0 per cent by 2016-17.
  • Monetary policy committee

  1. The panel felt that the monetary policy decision-making should be vested with a monetary policy committee (MPC).
  2. It went on to recommend that the Governor of the RBI should be the Chairman of the MPC.
  3. It felt that the Deputy Governor in-charge of monetary policy could be the Vice-Chairman.
  4. The Executive Director in charge of monetary policy could be its member. It could have two external members.
  5. The full-time external members would have full access to information/analysis generated within the Reserve Bank. “
  6. The term of office of the MPC could be three years, without prospect of renewal.
  7. Each member of the MPC will have one vote with the outcome determined by majority voting, which has to be exercised without abstaining. Minutes of the proceedings of the MPC will be released with a lag of two weeks from the date of the meeting,’’ the committee said.

Monetary Policy Committee, 2015

  • 1st time suggested by Y V Reddy Committee. Then Tarapore Committee (2006); Percy Mistry Committee (2007); Raghuram Rajan Committee (2009) and FSLRC Committee (2013) and Urjit Patel Committee (2013) talked about MPC.
  • Monetary Policy Committee (MPC) was constituted as per Section 45ZB under the RBI Act of 1934 by the Central Government.
  • RBI Governor is the head of MPC.
  • There are 2 core tasks = Inflation targeting + Policy rate.
  • The major four objectives of the Monetary Policy are mentioned below:
    • To stabilize the business cycle.
    • To provide reasonable price stability.
    • To provide faster economic growth.
    • Exchange Rate Stability.
  • Center determines inflation target every 5 years. RBI maintains it.
  • 6 members of MPC =
    • RBI Governor, Deputy Governor related to MPC, 1 RBI Board member.
    • 3 Govt nominees appointed through Selection Committee consisting of Cabinet Secretary head, RBI Governor, Secretary of Department of Economic Affairs, Ministry of Finance and 3 experts.
  • Tenure is 4 years and they are not eligible for reappointment.
  • Decision is binding on RBI.
  • Quorum = 4 vote including RBI Governor.

What is the news?

  • India’s retail inflation cooled to 5.3% in August from 5.6% in July, thanks to food price inflation falling to 3.11% from nearly 4% in July, and the effect of a high base last August.
  • This marks the second month of marginal moderation in the Consumer Price Index (CPI), keeping retail inflation below the central bank’s upper tolerance threshold of 6% after hitting 6.3% in May and June this year.
  • The Reserve Bank of India is expected to continue with its accommodative monetary policy stance, with the headline inflation number edging lower.
  • However, economists warned that inflationary risks persist.

Source: TH


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