The curious case of Inflation combat: Financial Express, 15th June 2011

In the last 15 months or so, the Reserve Bank of India (RBI) has relentlessly pursued the goal of inflation control as the number appears to be quite intransigent despite all the positive developments in agriculture. The results have not been encouraging so far and the impact has been limited.

How do we tackle inflation then? The answer could actually be staring in front of us that we have not taken into account. To understand more, let us look at the composition of inflation in terms of what are the sectors that influence inflation. Broadly speaking, primary products have a weight of 20%, fuel products 15% and manufactured goods 65%. Inflation has been relatively high in all the sectors by the pre-2009 standards and each of them is guided by a different government body that has influence over prices.

Let us look at primary products. Here the ministry of agriculture (MoA) has maintained that FY11 has been one of the best for agriculture. Yet prices have been rising and all the assurances of good monsoon, robust kharif and an ecstatic rabi harvest has not helped bring down prices. This is partly due to the fact that the ministry has been instrumental in increasing the minimum support prices (MSP) of all farm products. In the last 2 years, it has been increased by between 10% and 30%, which means that there is an inherent tendency for prices to go up as market benchmarks are increased. Last week, the MSPs were raised once again by the Cabinet Committee on Economic Affairs (CCEA) across pulses, cereals, oilseeds and fibres. This means that there is an inherent upward bias in the market even though the government physically only deals in procurement of wheat and rice. By counter-intuitive reasoning, it may be concluded that MSPs have driven inflation since the government maintains that the high MSPs have helped to shift crop patterns and increase output. Here we are not passing a value judgement on whether it is justified or not.

Now let us look at the fuel prices that are increasing by around 13%. Higher crude oil prices make state-run oil marketing companies unviable and there is this constant call to align petro-product prices with those in the market (including by economists). The ministry of petroleum (MoP) decides on the pricing policy. Motor spirit prices directly feed into inflation with a weight of around 1%, while diesel comes with a direct weight of close to 5% and an indirect influence of 0.75-1% on prices. Although it makes economic sense to increase prices, it also adds to inflation.

Then there is the ministry of finance (MoF), which has its opinion on the subsidy bill on food and oil. To ensure that the Fiscal Responsibility and Budget Management (FRBM) targets are adhered to, it is reluctant to increase its expenditure and hence deficit, and is exerting pressure on the MoP to increase fuel prices. Curiously, the government can enhance its expenditure without the fear of being caught in the RBI’s web of increasing interest rates as it gets its funds through the regular auctions, which come in at an average rate of around 8.4-8.5%.

The last sector, manufacturing, is the one which generates core inflation (non-food and fuel). If manufactured food products and textiles are excluded (as they are agro-based), then this group accounts for 45% of inflation and core inflation would be only 5% in April 2011. In fact, since April 2010, this entire group has shown an increase of between 5% and 6.5% consistently until April 2011 with limited volatility. This is where RBI policy can work.

But for this to happen we need to answer some questions. First, is consumption supported by bank finance increasing demand of houses (mortgages) or automobiles or consumer durable goods? Is investment by industry growing rapidly? Is industry holding on to large inventories? If the answer is yes, then interest rate hikes will lower demand by increasing cost of credit. But if the answer is a shoulder shrug then we may be barking up the wrong tree by raising rates.

The point that emerges is that we have a situation where different arms of the government are speaking different languages and expecting RBI to tackle inflation. So we have a case of food and fuel prices increasing on which RBI has no control—after all, no one borrows money to eat food. The poor anyway continue to starve as they are not credit worthy. Therefore, RBI may be forced to treat a malaise over which it really has limited control.

What is the solution? The MoA, CCEA, MoF, MoP and RBI should all sit together and discuss the inflation strategy. Currently we have every authority looking closely at its own jurisdiction and taking decisions to ensure that their houses are clean, while RBI has the tough job of finding solutions to inflation. We certainly must have all these ‘arms’ talk to each other continuously with a macro eye. This will ensure that we have a singular approach to inflation and eschew this seemingly chaotic situation where RBI is on one side and the others are pulling the strings in the other direction.