RBI firefights, but inflation buck stops solely with government

In the absence of inflation targeted policy reform in New Delhi, Mumbai will continue raising rates

India’s economic growth may have slumped to a decade low of 5%, but the governor of the Reserve Bank of India(RBI) is more worried, rightly so, about rampant inflation that’s almost become a chronic disease in the country. Wholesale inflation is at a 7 month high of 6.46%, while retail inflation is nearing the 10% mark, way above the central bank’s comfort zone. What’s more the RBI expects inflationary pressures both at the CPI and WPI level to remain higher than current prices through most of the remaining part of this year, driven up primarily by food and fuel prices. 

 

“Notwithstanding the expected edging down of food inflation, retail inflation is likely to remain around or even above 9% in the months ahead, absent policy action” said Raghuram Rajan, Governor of the RBI in his policy speech yesterday. 
 

‘Absent policy action’ – is the operative line that Rajan would want to underscore and have the government to take note of. Many argue that making borrowing more expensive can have only have a limited impact on curbing demand in the economy. This is illustrated by the fact that 13 rate increases between April 2010 and October 2012 did not have any desired effect in bringing inflation down according to Diwakar Gupta, former managing director of the State Bank of India. In this backdrop, the onus is solely on the government to address structural supply side issues on food inflation, as well as reduce expenditure to curb runaway demand and rein in the fiscal deficit. 

 

The government has shrugged away the need for concentrated action on structural inflation for far too long, saying repeatedly that it will come down with the usual seasonal moderation. But neither the RBI, nor economists believe the government, and there is reason for it, perhaps best illustrated by the onion example. 
 

Onion prices went up 323% on-year and 22.66% on-month. No doubt there was a slight dip in production due to unseasonal rains damaging crops, which should have pushed prices up a little. But what explains the dramatic rise? 

Structural policy inaction, of course. 
 

Supply side market distortions like alarming retail mark ups, rampant hoarding, and collusion between a few established traders who dominate the wholesale onion market extraordinarily, creating entry barriers for new entrants in the APMC mandis, has made the onion trade an unholy oligopoly. These are findings of the government’s own body last year  – the Competition Commission of India, but nothing much has been done to crackdown on the malpractices, as many believe middlemen have political blessings to maintain a status quo. The onion example can be extrapolated for vegetables as well which are up a whopping 89.37% on a y-o-y basis. 
 

The second instance of central policy failure again comes from the government’s quarters itself. Ajay Chhibber, director-general of the government's Independent Evaluation Organisation writing for the Business Standard earlier this month observed that rising procurement prices for cereals, way over the cost of production is another reason for prices shooting through the roof. 
 

“Over the last five years the procurement price of cereals has increased over the cost of production by almost 15-60 per cent for a cumulative differential of around 150 per cent. As a result, the food subsidy has increased hugely, doubling from around Rs 40,000 crore in 2008-09 to over Rs 80,000 crore in 2012-13 - and it is likely to rise further in 2013-14, as the new food bill is implemented and the issue price at which the grains are sold is reduced.” wrote Chhibber. 
 

It is unlikely that procurement prices will come down this year, ahead of the elections, but what’s more surprising says Chhibber, is that the government hasn’t released grain stock above the buffer stock norms to reduce prices. What it’s done instead is let millions of tons of grain rot, according to Sharad Pawar’s own admission. 
 

Last but not the least, is the matter of government expenditure which also has inflationary effects. While Chidambaram has reiterated time and again that he will maintain the 4.8% red line on the fiscal deficit by cutting non-plan expenditure, the RBI itself recently pointed out that it would be a challenge given the level of gross fiscal deficit (74%) during the current fiscal.
Also, even if deficit targets are kept, the government is likely to use accounting tactics like rolling over $15 billion in subsidy costs into next year’s accounts, indicating that fuel subsidies will not be materially trimmed, and the can will only be kicked further down the road. 
 

The government argues that raising fuel prices will have inflationary consequences. But experts point out that in the long run it will reduce the fiscal deficit and bring down demand, thus lowering inflation. In an election year though, the government is unlikely to think about the long run. 
 

This myopia of the government meanwhile comes at a massive cost to the common man.  
 

“It is important to break the spiral of rising price pressures in order to curb the erosion of financial saving and strengthen the foundations of growth. It is in this context that the LAF repo rate has been increased by 25 basis points… The Reserve Bank will closely monitor inflation risk while being mindful of the evolving growth dynamics.” said the RBI governor yesterday. 
 

This statement is amply clear in the fact that interest rates will continue to move upwards giving more pain to the consumer. If Rajan’s intention is to protect the erosion of the common man’s savings by offering even a small positive return, we are looking at another 1% increase in repo rates in the least (CPI is at 9.84%, SBI base rate is at 9.8% and 1-5 year term deposit rate is 9%. The differential between repo and bank base rate is generally around 2% and repo and bank deposit rates is around 1.25-1.5%). 
 

The question is, even if in a calibrated manner, will the RBI be bold enough to do this amid a din of protest from the government and corporate India? And if not, what was the point of a 25 bps hike in the repo rate?