The inflation hocus pocus

Would you trust your physician who, after months of prescribing and increasing the dosage of medication for your persistently high blood pressure, tells you that he may not have been entirely right in his reading of your health but that you will be all right soon?
Something similar has been happening with the Indian economy and the good doctors attending to it. Wrong inflation forecasts have hurt the UPA government’s credibility. That claim is hardly surprising, but the source from which it came recently is. Montek Singh Ahluwalia, the deputy chairman of the Planning Commission and arguably the second or third-most important economic policymaker in the country, has said words to this effect in a series of interviews, after the inflation rate stubbornly hovered around double digits despite continued tightening of credit.

He went on to say that the December figures which would be out in January would begin to show the downtrend and by the end of the financial year in March 2012, inflation would have receded to a manageable level of about seven per cent a year. Not too long ago, inflation fighters C. Rangarajan, the chairman of the Prime Minister’s Economic Advisory Council, and D. Subbarao, the Governor of the Reserve Bank of India (RBI), had pegged the annual inflation rate’s comfort benchmark at around five per cent.
Mr Ahluwalia will most likely get lucky and his forecast of a downturn in December figures will come true. That, however, would not indicate a sudden improvement in the government’s forecasting skills.
Food prices, or more accurately, vegetable and fruit prices, have been perhaps the most significant contributor to persistent inflation in the last two years. Anyone with the slightest familiarity with subzi mandi knows that cooler weather is accompanied by a marked improvement in vegetable supply and an attendant drop in prices. Weekly food inflation figures for the most recent four weeks ending on 26 November have shown a decline from over 11 per cent to 6.6 per cent and the trend will continue for the next two months at least. That in turn will bring down the overall inflation rate as well, no thanks to government policies. Whether the lower rate persists once the seasonality factors are non-operative would be the acid test.
Numbers on inflation are not the only ones our policymakers and economists have got wrong. The latest data shows that for the first two quarters we have experienced growth below seven per cent a year, but finance minister Pranab Mukherjee is still bravely asserting that the year will end with 7.5 per cent growth. Given other disturbing phenomena — global downturn following the Eurozone crisis, industrial growth running out of steam, mounting trade and balance-of-payments deficits, a marked decline in global fancies for India, policy paralysis and, of course, stubborn inflation — could well reduce Mr Mukherjee’s optimism to mere whistling in the wind.
Arguments would no doubt be forthcoming that even a sub-seven per cent growth is creditable in the current circumstances. But they’d overlook the fact that six per cent is now the Hindu rate of growth. Anything less than that causes serious problems all around. For example, the Budget deficit is predicated upon a certain level of revenues arising from the presumed rate of growth, but the expenditure is firmly committed, especially to subsidies, wages and pensions, interests and, most of all, the expansive welfare programmes such as the employment guarantee scheme, soon to be joined by an equally ambitious food security programme.
If economic growth slows down, especially if it is closer to six per cent, the actual deficit balloons. Mr Ahluwalia offers little comfort when he says that the structural deficit — that is, the one based on original estimates — would not change; this is mere tautological play on words! What matters is the actual deficit and if it goes past, say, five per cent of the gross domestic product (GDP), the usual suspects — raging inflation, downgrades by rating agencies, and capital flight — will come to haunt the Indian economy with renewed strength, at least in the medium term.
Therefore, we can expect some cheerleading in the estimates offered by government spokespersons lest panic spread. But policy wonks and mavens, ever eager to rush to the nearest network camera, have also mostly suffered from a credibility deficit. And not just in India. Most American economic analysts, except Nouriel Roubini, failed to read the gathering sub-prime storm before the cataclysm of Lehman Brothers in September 2008. The doyen of the Federal Reserve System, Alan Greenspan, had to famously admit that he was blind-sided.
The increasing sophistication in model building duly recognised by those who award the Nobel has led to a false sense of confidence among economists that theirs is an almost exact science with accurate predictions. But economics is a very strange kind of science which does not follow immutable cause-and-effect relationships. Seemingly contradictory hypotheses can happily co-exist in economics and yesterday’s theories and oracles grace the dustbin today.
The government is clueless about inflation. Policy wizards from the Prime Minister down are clutching at straws, as was evident from their faith in the proposed retail reform being the remedy for rising prices.
The resort to incremental squeeze on interests, which succeeded during the Rangarajan regime at the RBI (1992-1997), has not worked. The past, it seems, is of limited utility in both the diagnosis and prognosis of economic problems. Each situation calls for a degree of playing by the ear and trial and error, as any physician worth his stethoscope would tell you. In medicine, that which works is a good line of treatment; so it is in economic management, though we don’t ever know for sure what will work in any given situation!
John Kenneth Galbraith said it all: the only purpose of economic forecasts serve is to make astrology look more respectable!

The writer taught at IIM Ahmedabad and helped set up he Institute of Rural Management, Anand. He writes on economic and policy issues.