Tough trade-offs in inflation control: Financial Express JUne 2, 2014

One of the immediate tasks for the new government is to tackle inflation. This economic phenomenon has been the Achilles' heel for the last 4 years. Ironically, it has come at a time when we have had good harvests with price pressures being manifested in the primary and fuel articles categories. Surprisingly, inflation when viewed for only manufactured products, has been the lowest averaging around 5% going by the WPI while primary and fuel products have registered increases of 8.3% and 7.9% respectively. While there is a lot of debate on whether RBI should lower interest rates or increase them and whether the government is spending too much money which is inflationary, conventional economic theory has actually been turned around, as these hypotheses may not be holding today. First, has high government spending been responsible for inflation? Theoretically, it can be argued that when the government spends beyond a limit, there is too much liquidity in the system which drives prices up. Here the assumption is that there is excess demand for various commodities. But when inflation is on the side of food and fuel, this theory cannot be ratified. Further, RBI data shows that industry, as of December 2013, was operating with capacity utilisation levels of around 74%, which means that it could respond well to demand with the existing capacity. Further, if one looks at the inventories of the manufacturing sector, the ratio of finished goods to sales is around 18% while that of raw materials to sales is 25%. This again indicates that demand is slack and industry has the means provided someone provides demand. The problem is one of shortfall and not excess demand. Second, a counter argument put is that the MGNREGA programme put a lot of money in the hands of individuals which though serving a social objective did not make economic sense as assets were not created and money was given to be spent. As an extension, this wage drove up wages in other sectors too as the minimum wage level went up thus exacerbating demand. Looking at MGNREGA on its own, total outlay was around R30,000 crore per annum, which often turned out to be lower than budgeted. Even so, this amount is around 1.5% of GDP from agriculture or 1% of value of output. Clearly, this amount is too small to influence prices. Also, given that MGNREGA or minimum wage paid is not to the destitute but to workers between two harvests, the money would have been spent on non-food items, which also provided demand for consumer goods in rural areas and spurred industry to an extent in the good years. CSO data affirms this thought as the share of food items has fallen in the consumption basket with cereals and pulses coming down appreciably. Third, as food prices have gone up even with output touching peak levels the reason could not be on excess demand side, but higher MSPs being offered by the government relentlessly. High prices of today feed into the calculations tomorrow, thus leading to the CACP announcing high prices. This cycle needs to be moderated or else food inflation will be a continuous spiral. Fourth, the government has been caught in a dilemma on fuel prices. This is a decision taken keeping in mind fiscal prudence and is dependent on global crude oil prices and the exchange rate. With one of the two playing truant, the higher cost is being gradually shifted to the consumer with petrol being fully market-driven and diesel being calibrated steadily. This has led to this category witnessing an increase of almost 8% in the last 4 years. In FY14, fuel products with a weight of 14.9% contributed to 28% of inflation coming after primary articles with 44% (weight of 20.1%) and manufactured goods with 28% (65%). We evidently need to make a bold admission that as we strive for prudence on the fiscal side the nation has to bear up with high inflation. Fifth, RBI has been using interest rates as a tool to combat inflation. But the focus has actually changed from a tool to lower inflation to a 'reaction to inflation'. By increasing the repo rate by 75 bps last year (after starting off with a 25 bps cut), the base rate rose by just 15 bps which may have only marginally contributed to the stagnant growth in credit which was marginally higher at 14.3% in FY14. More importantly, interest rates do not affect inflation on primary or fuel items which contributed to 72% of WPI inflation and is impervious to interest rates as such purchases are not leveraged. In terms of CPI inflation in FY14, around 77% of the index (food with a share of 59% in inflation, fuel 8% and housing 10%) are not quite affected by monetary policy. Therefore, monetary policy is now more of a reaction to inflation with an eye on real interest rates which in turn probably acts as a deterrent for households to prefer financial savings to gold. Sixth, the issue of imported inflation is also a factor that the government will have to keep in mind. Last year, the rupee fell by 11% on an average basis. Imports as a proportion of GDP was about 24% which means that up to around 2.5% inflation could have been caused by the declining rupee depending on to what extent the higher cost was passed to the consumer. What does all this mean? Of the 6 factors discussed, fiscal spending or interest rate policy may not be suited to bringing down inflation which also means that turning the blame on MGNREGA is not right. Inflation on rupee movement would be external to the system. But the government finally has power over pricing of fuel and farm products, and should look seriously in these corners as it can make a difference. Assuredly, these trade-offs are not really easy. They are tough.