Inflation Conundrum: Business Line 9th May 2007

The inflation conundrum
Madan Sabnavis

The year 2006 will be a monetarism landmark, not only because of the exit made by the great economist, Milton Friedman, or the recognition bestowed on Edmund Phelps, who added a new dimension to the legendary Phillips Curve. But because most monetary authorities the world over struggled to check inflation and used interest rates and bank reserve requirements to contain the price surge. Whether it was Y. V. Reddy (Reserve Bank of India Governor), Ben Bernanke (US Federal Reserve chief), Jean-Claude Trichet (European Central Bank President) or Mervyn King (Bank of England Governor), all were no doubt looking into textbooks for clues to inflation control via monetary policy.
Inflation is perceived as a a monetary phenomenon and indeed this is why monetary authorities derive their importance.The recent increase in the cash reserve ratio (CRR) by the RBI was a desperate response to galloping credit growth that could lead to a surge in inflation, which has not been contained despite all previous measures of monetary control.
Theoretically, if aggregate demand exceeds supply then there is pressure on prices. Demand is up because of easy access to money, created by the banking system through credit. Raising interest rates would make credit costlier and hence the demand for it would fall. Supply is denoted by the existence of spare capacity. Typically, demand-pull forces would also be reflected in the increase in the prices of manufactured products.
The other side of inflation is the cost factor. Inflation tends to rise when there are shortages in the economy. A sub-optimal monsoon, for example, would lead to higher prices as food supply is affected. Closely associated with inflation on the supply side is the crude oil factor; but as a country like India has little control over this global phenomenon, the inflation it causes is called `imported.'
Inflation analysis
Inflation analysis can be looked at from both the demand and cost sides. From the RBI's point of view, monitoring the growth in credit means targeting money supply. Traditionally, the money supply target has been around 15 per cent, consistent with a GDP growth of 7.5-8 per cent. In four of the last seven years, the money supply growth has been over 15 per cent and in two, inflation has broken out of the RBI band of 5-5.5 per cent. So, the RBI has generally managed well the inflation through some careful fine-tuning of the CRR and reverse repo rates.
If the inflation rate is considered high, beyond 5.5 per cent, then India has had high inflation in three years. Inflation was associated with supply factors, with zooming fuel prices the cause in two years, and high primary prices in one. In FY-2001, the money supply growth was high, but was checked by monetary tightening. Both money supply growth and increase in primary prices exposed the economy to demand and supply shocks.
FLIP SIDE
There is an unusual relation between rise in the prices of primary products and agricultural production. Typically, a fall in production should lead to higher inflation. But this has not always been so and can be explained by governmental action; by offloading of stocks or importing, supply of food products is ensured and this keeps the price rise in check. However, in FY-2007 this does not seem to have worked. For, in expectation of lower growth in agricultural production, there has been a significant rise of primary products.
There is a flip side to the equation too: High growth in agriculture being associated with higher inflation. This happens for two reasons - one, statistical mirage formed as a negative growth in one year andsucceeded with a positive growth. And, two, the lagged effect when prices move to adjust to the market forces.
Moreover, there has been a tendency for the government to raise support prices when output is down, which fuels inflation with a lagged effect.
Higher primary product prices in FY-07 are, however, reflective of slower growth in the agricultural sector, especially in the area of food crops. Industrial inflation depends on two sets of factors: the state of industry and the level of excess capacity. Prices have tended to rise from FY-03, and this called for higher investments.
In FY-06, when fresh capacity came on, prices were down. But, again in FY-07, prices have started moving up as optimal capacity utilisation was achieved as indicated by the average rate of around 82 per cent. Prices would tend to increase until the new capacities come on line.
Inflation thus will ever remain a monetary phenomenon because the only lever available is controlling the demand-pull forces. The others are inappropriate for all practical purposes.
Monetary policy can hence be likened to driving a vehicle with one hand on the interest rate lever to check demand-pull forces, while keeping an eye on global crude oil politics and industrial capacities besides, of course, sending up a silent prayer.