Managing Inflation in India: shift from supply driven to demand driven inflation

Subir Gokarn has this nice write up on India’s inflation issues (somehow most of the recent posts have been on India inflation). He shows how inflation has moved from a supply-side constraints driven trend to demand-side pressure one .
And accordingly monetary policy has responded over the time period. He points to 4 issues that have “influenced the sequence and magnitude of the monetary actions”:

First, even while the Indian economy has recovered quite rapidly from the slowdown, there is persistent global uncertainty. EMEs have generally done quite well in coming out of the crisis, but a major part of the global economy – the US, the UK, the Euro zone – is not only showing only very modest signs of recovery, it is also manifesting new stresses, partly as a result of the huge build-up of sovereign debt, which governments used to support their various fiscal stimulus packages. Given these linkages, the risks from the global economy need to be taken into consideration while formulating domestic policy.

Second, the reality is that the policy instruments are far from being in a normal position. As the economy recovers, it is imperative that policy instruments be brought as quickly as possible back to a position consistent with the state of the economy. This is essential for the management of expectations as well as to re-create the capacity to respond, should another shock hit the economy. But, as important as it is to return to normal quickly, it is equally necessary to do so non-disruptively. The kind of rapid and massive reductions that were made to instruments during the crisis simply cannot be replicated in the reverse direction.

Third, notwithstanding the above two issues, the fact is that inflation has taken hold, with both supply and demand pressures contributing to it. Monetary policy must respond. The table indicates that it indeed has. Action on rates and liquidity, through the CRR, began in January and has continued at the measured pace indicated earlier over the past six months. One strong criticism of the Reserve Bank’s approach has been that has been “too little, too late”. I would submit that the test of this is yet to come. It is well-known that monetary policy acts with a lag. It could be anywhere between 6 and 12 months, even longer before demand side pressures abate in response to an action. Given this, actions taken during January-July 2010 should start to show their impact on inflation over the next 6 to 12 months.

Finally, as I have already mentioned, an important lesson from the crisis was the critical role of liquidity in the financial system in maintaining economic stability. The policy approach over the past few months has been very conscious of the need to balance the exit from an abnormally high liquidity situation, which the response to the crisis created with the current liquidity requirements of both the public and private sectors.

A nice short analysis on India’s inflation trends.
(courtesy: www.mostlyeconomics.wordpress.com)