“EXPLAINING INFLATION IN INDIA: THE ROLE OF FOOD PRICES” By Prachi Mishra and Devesh Roy

1. “EXPLAINING INFLATION IN INDIA:THE ROLE OF FOOD PRICES”By PrachiMishra and Devesh Roy Comments: T.N. Srinivasan India Policy Forum 2011: July 12, 2011

2. 1. Measurement Issues: Not adequately Discussed • Measurement of Inflation in India – unsatisfactory state of price indices – Srinivasan, T.N. (EPW, June 28, 2008) and in Jayaram and Deshpande (2008). • WPI is neither a Producer Price Index nor a Consumer Price Index. It does not include services. • CPI for four different sections of the population of the past has been replaced by two only recently. Problems with weights and price data.

3. NSS household survey data not generally used in price index formulae – NSS data include services . Angus Deaton has compared unit values from NSS surveys with price data used in CPI.

4. 2. India’s Price Indices: What do they measure? • Fixed Weight Laspeyre Indices with periodically changing base periods, commodity composition and weights. • WPI Index at I (t) at period t by definition is 100 times the ratio of a given fixed weight bundle at nominal prices of t to its value at nominal prices in base period normalised as 100. • The index at t for any component of WPI such as food is defined in a corresponding and consistent way as WPI.

5. Again in a purely arithmetical way index I (t) for any t could be equivalently expressed as the average growth rate between O and t of the nominal value of the fixed weight bundle. Analogously any index for a component of I (t) can be equivalently expressed as the average growth rate between 0 and t of the nominal value of each component.

6. 3. Price Indices as Proxies For Inflation • Using the average growth price indices between 0 and t as a proxy for inflation requires a definition for inflation. • Inflation between 0 and t is defined as a simultaneous increase in the nominal prices of all commodities at the same rate during that period. Inflation in this very strict sense is very rarely seen empirically. • The strict definition could be relaxed by associating inflation with simultaneous increase in the price indices of all components at the same rate between 0 and t. Even this relaxation turns out to be inadequate.

7. Conventionally inflation between 0 and t is defined as an increase in the price index of all commodities between the two periods. Almost everywhere else a CPI is used as the prime index in inflation definition. But WPI is used in India. • In the conventional usage, calling an increase in the price index for a component (e.g. food) as inflation in that component, (e.g. food inflation) is not appropriate. • For example, if the aggregate index does not increase between O and t while the food index does, a more meaningful description of the situation is a rise in prices of food articles relative to the bundle of goods in the aggregate index. Distinguishing relative price changes from inflation is essential for analysis and the use of the terms food inflation, oil inflation, etc. are best avoided.

8. 4. Economics of inflation: Microeconomics of relative price determination, macroeconomics of nominal prices and inflation. • Friedman once quipped that “inflation always and everywhere is a monetary phenomenon”. Whether one agrees with him or not, one cannot meaningfully analyze inflation without modeling the monetary sector and monetary policy. • Any sound empirical/econometric analysis has to be founded on a well specified theoretical model. Its empirical counterpart for estimation has to be based on an appropriate econometric framework. Modeling inflation requires a conceptually well founded model integrating real and nominal (financial) sectors. In my view no integrated model with solid microfoundations(and not ad hocerysuch as “cash-in-advance” constraints)exists. • By necessity all theories and models are abstractions of reality and what phenomenon are included (excluded from) in the model are matters of judgments. Date are invariably proxies for their counterparts in a theoretical model. For these reasons appropriately executed checks for the robustness of empirical results with respect to a relevant set of alternatives to the phenomena included (exclude from) in the model and the proxies used are essential. • Unfortunately there is no well specified theory that motivates the empirics and no robustness checks in the paper for its empirics.

9. 5. Empirics of the paper and alternatives in the literature. • Section II of the paper describes the data and the rationale for using WPI as the index for the analysis. Although this is common practice, for reasons I already mentioned the use is very problematic. Its weights are quite different, for example from the shares of corresponding commodities in the household expenditure data, CPIs are rejected for reasons that they are not notional, there is not enough commodity disaggregation and they are not commonly used for policy reasons. None of these taken by itself is strong enough to reject the use of CPIs altogether but only to use them with a framework that recognises their limitation. It is surprising to be told that CPIs are its choice of policy rates but other policies such as those oriented to improving welfare of the poor do use CPIs.

10. Section III on trends in WPI is just descriptive. Strangely after rejecting CPI in Section II, it is used in Section III but without stating which of the four CPIs is being used. • Section IV is on the importance of food index in driving overall inflation. Both trends in food index and the aggregate are joint comes of the path of other variables some of which are endogenous policy variable such as monetary and trade policy which could be lagged response to price trends or alternatively to expectations of future trends and also exogenous shocks. I expected to see a behavioural model in the paper incorporating these for analyzing the two indices. I did not. • Section IV is mostly on time series properties of price indices for food and non-food. Tables 1-3 show the results. The persistence of price changes for food as well as non-food is interesting but there is no explanation from a behavioural perspective as to why the null of no persistence is the natural one. The reference to the build-up of inflationary expectations is cryptic since again the model does not seem to include expectations about the future and responses to shocks in them in terms of crop areas, inventories, etc.

11. The existence of co integration among variables, if as it is usually interpreted as the existence of a long run equilibrium relationship between the variables, if my understanding is correct, does not imply anything about the direction of pass through among them. Purely temporal causality tests such as Granger’s or Sims’ reported in the paper are also not adequate for this purpose. • I would hesitate the estimated relation of pass-through from food prices to non-food prices in Table 3 as a causal relation. As such the implication in the pages that “food inflation” is analytically an important driver of “overall inflation” is not well founded. • Section V is another descriptive section even though its title “which commodities drive food-price inflation” would suggest otherwise.

12. Section VI on “what factors explain the rise in food inflation? Case studies of Specific Commodities” lists several plausible factors, including demand, supply, trade, public policy, etc. Rightly the distinction between their short term and long term effects is also mentioned. But once again there is no dynamic structural model with behavioural foundations behind the inferences in the section. For example, foreign trade policy in India with respect to food grains, edible oils, sugar, etc. seem to be in large part a response to domestic shocks as reflected in their domestic prices calls for careful modeling of policies and their consequences. There are infamous examples of onion exports being banned if its domestic price rises to high level during general elections, cotton exports being banned to please the domestic textiles lobby and exports of food grains by private trades encouraged with subsidies when public stocks accumulate to high levels, etc. • Section VII is on Conclusion and Policy Implications. My remarks thus far indicate my skepticism about the policy implications as following logically and analytically from the previous sections. Many of them sound plausible, but plausibility is one but by itself it is not enough to validate a policy recommendation. I am sure the authors will provide a deeper structural model based analysis. There are a number of papers in the literature such as that of PV Srinivasan and ShikkhaJha published in 2011 using a general equilibrium model of price formation and including trade policy response to domestic prices. There is a paper of Dasgupta et al from the Department of Economic Affairs of the Ministry of Finance on a time series analysis of wheat price formation and food price inflation.