Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 4 Monetary Policy and Inflation

Inflation: The Indian Experience

Price stability has been an important objective of monetary policy in India. Compared with many developing economies, the Indian inflation experience can be considered satisfactory, despite recurrent supply shocks and continuing fiscal imbalances. This is attributed to relatively better monetary management coupled with judicious supply management through buffer stocks of foodgrains and imports of sensitive commodities which contained the adverse effects of supply shocks and reined in inflation. Nonetheless, inflation increased during the 1970s and remained high thereafter till mid-1990s. In the period since 1996-97, inflation has edged lower reflecting concerted policy efforts.

Annual rate of inflation measured by variations in the wholesale price index (WPI) over the past five decades averaged 6.6 per cent in India. Inflation was very low during the 1950s averaging 1.7 per cent, but was quite volatile and annual inflation ranged between (-) 12.5 per cent and 13.8 per cent. The volatility was mainly on account of agricultural failures. Inflation accelerated to 6.4 per cent during the 1960s partly induced by the two wars during 1962 and 1965 and crop failures in 1965-66 when agricultural production fell by more than 16 per cent.

Inflation accelerated further during the 1970s due to both supply and demand shocks. The supply shocks emanated mainly from oil and food prices. Reflecting the first oil shock of 1973, import price deflator (measured as year-on-year changes in the unit value index of imports) surged by 43.0 per cent and 72.8 per cent during 1973-74 and 1974-75, respectively. In line with the sharp increase in average international crude oil prices by over 250 per cent in 1974, domestic fuel prices increased sharply from an annual average of about 4.7 per cent during the three years preceding the first oil crisis to about 26.5 per cent on average during the three years beginning 1973-74. The adverse impact of the oil price shocks got accentuated by the drought conditions in 1972-73, 1974-75 and 1979-80 which resulted in significant declines in agricultural output. Thus, higher fuel prices and agricultural commodity prices got reflected in overall inflation . Sharp increases in money supply - even as output growth decelerated during the 1970s - added to demand pressures. Consequently, inflation moved up further in the 1970s, averaging about 9.0 per cent.

During the 1980s, demand pressures emanating from an expansionary fiscal policy and its monetisation coupled with intermittent supply shocks kept inflation high. Inflation averaged 8.0 per cent per annum during the 1980s, somewhat lower than that of 9.0 per cent per annum during the 1970s. Fiscal deficit of the Centre widened from 3.8 per cent of GDP during the 1970s to 6.8 per cent during the 1980s. A large part of this burden was borne by the Reserve Bank - almost 32 per cent of the fiscal deficit was financed by the Reserve Bank during the 1980s (25 per cent during the 1970s). Monetised deficit almost doubled from 1.1 per cent of GDP during the 1970s to 2.1 per cent during the 1980s. Consequently, the net Reserve Bank credit to the Centre expanded by 20.0 per cent per annum during the 1980s as compared with 14.5 per cent per annum during the 1970s and this led to an acceleration in reserve money growth. Broad money growth could, however, be contained to rates lower than the 1970s, as a result of increases in cash reserve requirements. Exchange rate pressures also added to inflation. Exchange rate of the rupee vis-a-vis the US dollar depreciated by around seven per cent per annum during the 1980s in contrast to less than one per cent annual deprecation during the 1970s. Supply shocks added to inflation pressures. During the second oil crisis, average international crude oil prices increased by over 130 per cent in 1979. Concomitantly, domestic fuel price inflation increased sharply from an average of below 4.0 per cent in the three years before the crisis to an average of above 20 per cent during the three years of the crisis beginning 1979-80, with a peak of 25.3 per cent in 1980-81. After reaching 18.2 per cent in 1980-81 due to the second oil crisis, inflation remained in single digit throughout the 1980s.

Empirical evidence confirmed the adverse effects of excessive monetary expansion, emanating from the monetisation of the fiscal deficit, on inflation. The experience of the 1980s also highlighted the inflation-fiscal-monetary nexus. Because of higher elasticity of government expenditure with respect to inflation relative to that of government receipts, higher inflation meant an enlarged fiscal deficit which, in turn, necessitated increased monetisation. This led to a further increase in inflation, starting a vicious circle of high inflation, high deficits and high monetisation.

Inflationary pressures accelerated in the first half of the 1990s. High fiscal and current account deficits of the 1980s culminated in the balance of payments difficulties during 1990-91. As part of the macroeconomic stabilisation programme and structural reforms undertaken in the aftermath of the crisis, exchange rate depreciated substantially. Between end-March 1991 and end-March 1992, the Indian rupee depreciated by nearly 37 per cent. Notwithstanding the limited openness of the Indian economy, this order of depreciation added to inflationary pressures. The exchange rate depreciated by more than 11 per cent per annum during the first half of the 1990s, almost double that during the second half of the 1980s. Hikes in procurement prices as well as supply-demand imbalances in essential commodities like pulses, oilseeds and edibles oils further added to inflation. A part of the hike in procurement prices was intentional so as to restore the terms of trade for agriculture. Primary articles inflation accelerated to 18.1 per cent in 1991-92 from 13.0 per cent a year back. Extremely low foreign exchange reserves - foreign currency assets at US $ 2.2 billion at end-March 1991, equivalent to less than one month of imports -constrained the ability to import to meet the demand gaps. The sustained rise in fuel prices at a double-digit rate (of about 13 per cent) in the first half of the 1990s had its impact on inflation not only directly but also through the second round effects.

The phased opening up of the Indian economy also added to inflationary pressures. This emanated from large capital inflows during 1993-94 and 1994-95 and, despite a number of steps to sterilise them, monetary expansion remained well-above the desired trajectory. As a result of the combined effect of these factors, the first half of the 1990s saw a sharp increase in inflation which averaged 11.0 per cent, higher than the average of 8.0 per cent during the 1980s. The focus of monetary policy in the subsequent period, therefore, shifted towards containment of inflationary pressures in the economy.

Despite substantial capital inflows and high fiscal deficits in the period since 1996-97, inflation could be controlled. Inflation averaged around five per cent in the period 1996-97 to 2003-04, less than one-half of that during the first half of the 1990s and the average of 8-9 per cent during the 1970s and the 1980s. In fact, even in a year such as 2002-03 when the country faced its worst drought of the past two decades, inflation remained moderate. Not only that, the year 2002-03 was marked by the simultaneous impact of several other adverse developments such as border tensions and high international crude oil prices. As the Reserve Bank's Annual Report, 2002-03 observed that, "in the past, the occurrence of any one of the shocks experienced in 2002-03 in isolation had produced a sharp loss of growth, higher inflation, balance of payments difficulties, and even financial instability in the economy. Seen in this context, the performance of the economy during 2002-03 demonstrates the developing resilience of the Indian economy. This suggests that perseverance with structural reforms, despite the drag of slower growth in the second half of the 1990s, has helped to relatively shock-proof the economy and sustain a stable macro-economic environment".

A number of factors explain the lowering of inflation and inflation expectations since mid-1990s. First, the Reserve Bank could largely contain money supply to levels consistent with its indicative inflation projections. This was despite a large order of capital inflows from abroad and the consequent build-up of reserves. As elaborated in Chapter IV, the expansionary effect of large forex purchases was sterilised effectively by resorting to a number of steps, especially open market sales of Government securities and a judicious use of Liquidity Adjustment Facility (LAF). Moreover, the increased flexibility due to the improved monetary-fiscal interface and reforms in the Government securities market enabled a lower degree of monetisation of fiscal deficits. In particular, market-determined yields on Government securities encouraged banks to willingly hold Government securities and this reduced the pressure on the Reserve Bank to finance the Government. Net Reserve Bank credit to the Centre, in fact, recorded a negative growth in contrast to double-digit growth over the previous. There was a perceptible deceleration in the M3 two and half decades. Growth rate from around 18 per cent during 1990-95 to around 16 per cent during 1995-2004 even as real GDP growth accelerated from 5.0 per cent to 6.1 per cent over the same period.

Second, supply pressures from food prices eased as food articles inflation halved from around 12.0 per cent to around 6.0 per cent, led by a deceleration in procurement price increases. This decline, in turn, could have been enabled, inter alia, by a reduction in the headline inflation. Third, containment of global inflation reduced external pressure on domestic prices. Increase in import prices (as measured by unit value index of imports in rupees) was somewhat lower than that in the first half of the 1990s. Fourth, the exchange rate showed a significantly lower order of depreciation than in the first half of the 1990s: around four per cent per annum compared to 11 per cent. Moreover, as the results of an empirical exercise (discussed later) in this Module show, there is some evidence of a decline in exchange rate pass-through to domestic prices. A lower order of depreciation coupled with a decline in pass-through could have also helped in containing domestic inflation. Fifth, large buffer stocks of foodgrains have provided cushion against undue pressures on food prices through timely release of stocks. Sixth, the high level of foreign exchange reserves adds to comfort in supply management through imports of essential commodities. Adequate food stocks and foreign exchange reserves enabled not only the reduction in inflation per se but also contributed to lowering inflation expectations on a sustainable basis. Inflation expectations are quite critical. The effectiveness of monetary policy depends as much on the public's expectations about future policy as upon actual actions. Successful monetary policy is not so much a matter of effective control of overnight interest rates as it is of shaping market expectations of the way in which interest rates, inflation and income are likely to evolve over the coming year and later.

Although inflation is not targeted per se, monetary policy in India has been formulated with indicative projections about inflation consistent with growth for curbing inflationary expectations. The projected inflation rate was gradually scaled down to around five per cent in recent years from around 7-9 per cent during the early part of the 1990s which helped in anchoring inflationary expectations and improving policy credibility. Inflation rate of around five per cent appears to be consistent with various research findings on the threshold inflation rate for India (Box V.5). However, even a moderate inflation rate poses a dilemma in an open economy. If the domestic inflation rate of an economy, however low it may be, is higher than the average inflation rate of its trading partners, it puts pressure on the exchange rate. In this context, the question of simultaneous balance of the internal and external sectors becomes a major issue.