Developing countries often experience faster economic growth rates than more developed nations. However, rapid growth doesn’t come without significant costs, whether they be inflationary or otherwise. Drs. Laurence Ball, Prachi Mishra, and Anusha Chari in their paper “Understanding Inflation in India” dive deep into discovering the core driving factors that caused inflation in India to skyrocket from 3.7% in 2001 to an unsustainable rate of 12.1% in 2010.
At first glance, some attribute India’s inflation to the same thing as many other countries’ key inflationary driver; fluctuations in the prices of food and energy. The Reserve Bank of India’s Governor Rajan leads a pack of mass speculation that “high levels of inflation may become embedded in the expectations of price setters” which Rajan labels as an “inflationary spiral”, or as I prefer to call it, a self-fulfilling prophecy. Simply put, the idea that higher inflation rates are caused by expectations, means that the economic forces that set prices are anticipating what they believe to be the upcoming period’s inflation rate. However, their very expectations now reflected in the prices are the cause of what they initially believed the inflation would be, ensuring its realization and hence why I call it a ‘self-fulfilling prophecy.’
Core Inflation versus Headline Inflation
The authors importantly highlight the differentiation between core and headline inflation, which is important in any conversation about understanding the sources of inflation.
Core inflation refers to an “underlying trend in the inflation rate determined by inflation expectations and the level of economic activity.” Basically, the core inflation observation is inflation that is driven by natural economic forces working over time. Headline inflation, the more volatile measure of the two, is core inflation with inflationary supply shocks added in. Short run supply shocks are often measured by the relative price changes of the two main drivers of inflation in any country: Food and Energy. It is for this precise reason, that core inflation measures price variations without considering the fluctuations in both the food and energy sectors.
The overarching goal of this important differentiation is to be able to discern a long-run trend of inflation rates for any particular economy over time, without the influence of short-term price variation. In India however, the food sector possesses the largest share of the aggregate economic output. Discounting the food sector from consideration in India’s economy over time would leave a measure that does not accurately represent a long run trend. Therefore, the authors instead try to work with a weighted median inflation measure, which does not discount the important industries, but rather does strip away most of the quarter-to-quarter outlying price fluctuations, resulting in a measure similar to the core inflation. Specifically, the paper studies the rate of change in the headline Wholesale Price Index (WPI), and observes the core inflation in the WPI measured using a weighted median inflation rate. The Wholesale Price Index was chosen because beginning with data collected in 1994, it has a “relatively high level of disaggregation” of varying industries inflation rates, which was not available in the more commonly used Consumer Price Index (CPI), when the data collection began. The WPI has typically been the most common price index to measure inflation specifically in India.
The Indian Inflation Problem
Wanting to be among the “big boys” of advanced economies such as that of the U.S. and Europe, India is implementing specific monetary policy to work its economy at full power, so it no longer will be discounted in major global considerations. However, no vehicle can immediately become a high flying sports car, without progressing through the proper development. Most macroeconomic textbooks teach inflation through the classic Phillips curve model, where future inflation is dependent on expected inflation and supply shocks (which we discussed earlier), and the level of output of the economy relative to its historical output trend. As you can see, this model relies heavily on the most recent preceding inflationary data to predict the future set. It is this very model that advanced economies work to move away from as they become more developed, and it is this model that India is still unable to escape on its quest to more economic respect.
The main problem lies in something I’ve touched on but have yet to fully explain. Controlling inflation to create stable and sustainable growth is not easy, nor is it free. The authors in Understanding Inflation in India make a very cold, and fact-driven analysis on the economic conditions in India. Specifically, the concept of sacrificing output to reduce inflation can have severe consequences to the population relying on the sacrificed output. In India especially, the “output” that is so vaguely described in the paper, really refers to the food that so many men, women, and children rely on for their sustenance and their lives. I’ve mentioned that food is one of the primary drivers of the Indian Economy (and most economies for that matter). In India however, there aren’t many other significant goods and sectors, like manufacturing, for the economy to fall back on. Thus, an effort to control inflation isn’t simply a far removed monetary policy decision, but rather a directive that will immediately impact the lives of millions of Indians across the country.
The Effects and Potential Outcomes
With a decision that has the potential to affect the lives of so many Indians who already struggle to make ends meet, it is critically important to consider the impact such a decision will have on the already spiraling poverty and inequality. According to data from the World Bank, the poverty headcount ratio in India in 2009 at the $1.90/day poverty threshold, was 31.1%. With the understanding that so much of India’s economy is not only driven by, but also dependent upon the food industry, sacrificing output from that essential sector can devastate entire portions of the population further increasing the poverty headcount. Aside from being a horrific reality to consider, this would have adverse long-term economic effects as well.
Conclusion? Not Exactly
Unfortunately, the issues and dilemmas I’ve explained above, that are discussed in significantly more detail in the paper, are very real and immediate. There is no one right answer or solution to solving India’s current inflationary instability. It is certainly worth noting that as recently as early 2015, inflation has fallen to 5.2%, although there is nothing to anchor or lock in that rate. India faces economic uncertainty in the future which the Reserve Bank of India can only attempt to mitigate through various monetary policy implementations, and observing the results. The challenges lie in the fact that with such significant historical fluctuations, it is nearly impossible to discern a future trend. We can only hope that the Indian government continues to keep the best interests of its citizens at the forefront, and minimize any political turmoil that might hurt the lives of millions of Indians in the years to come.