Beyond the base effect on inflation: Financial Express: 22nd July 2010

There is a lot of talk of inflation coming down to 5-7% by harvest time—March-end. But is there any basis for this feeling? Also, while the WPI inflation numbers may show a downward trend with statistical props, will the pain of inflation actually be lessened? The truth is that we may be living in the delusion that WPI will come down. Come down it will, as the base numbers were high last year, and juxtaposing any moderate number will show lower changes and one may just feel tempted to uncork the bubbly. But, we may have to wait.

Let us look at some numbers first. In the last 12 months, the WPI has come down only once and remained unchanged on another occasion. This means that month-on-month, prices are going up. In case of food products, the index number has come down, albeit marginally, month-on-month four times and remained unchanged once, moving up seven times. The important thing is that to actually see relief in terms of lower prices, the index must come down. In the last 4 years, such a decline has been marginal during October-December even when the harvest was satisfactory.

The other question to be posed is whether a good harvest actually results in a lowering of prices. The answer is a shoulder shrug because last year’s experience has not been too encouraging. According to the fourth advance estimates of agricultural production, output of crops such as wheat, arhar, urad, cotton, etc, had shown an increase in production in FY10. Yet, the price increases registered ranged from 14% for wheat to 67% for arhar as of March 2010. Further, prices of spices, fruits, vegetables, milk and poultry products have increased sharply last year. These are products where prices are typically not mean-reverting and remain at the new levels. There is something amiss somewhere.

First, the fact that higher production has led to higher prices rebuts the theory that prices are rising due to supply shortages. Things have gotten out of control in the distribution process. One is not sure if farmers are earning more, middlemen are taking their share or distribution costs going up. The fact is that the CPI has increased almost commensurately. Second, the government has a role to play in stoking inflation. The high MSPs announced every year have lent an upward bias to prices. For FY11, the MSPs of rice and coarse cereals have been increased by around 5% and 15-30% for pulses. While most of these MSPs are not effective as they are not used by farmers to sell to the government since market prices are better, a higher base exerts an upward pressure on prices. Also, with excess procurement being undertaken for rice and wheat, there is less available in the market for private players, which has led to higher prices. So, we have an anomalous situation where production is normal, buffer stocks overflowing but prices increasing on account of a shortage in supply!

Third, the government has raised fuel prices to lower the losses of the OMCs. While the direct impact on inflation is around half a per cent, the total impact in terms of higher transportation costs for almost all products (50-60% of goods are transported by road in India), would be 1.1-1.2%. Lastly, some product prices, like oil and metals, are linked with international developments. Here, global prices are increasing, which means that there will be a tendency for these prices to also be resilient in the downward direction.

Under these conditions, how can one expect prices to actually come down? Higher inflation invariably feeds into the costs for farmers (diesel for running irrigation and transport). With the cost of living increasing and productivity stagnant, they have to perforce increase their prices. The other components are either induced (fuel) or beyond our control (manufactured goods).

If the government is keen on controlling cost-push factors, the concept of buffer stocks must be taken up. Procurement and buffer models must be revamped and buffers in sugar, pulses and cereals, in particular, must be considered as close-ended schemes. For other products like fruits and vegetables, organised private retail is the solution to improve production as well as stabilise prices.

At any rate, we need to have a clear policy framework relating to all these aspects: MSP, procurement, buffer stock, distribution, fuel pricing. Else, the pressure on monetary policy would be relentless as we take recourse to statistical base years to search for the right images.