Lurking threats

The inflation rate as measured by changes in the Wholesale Price Index (WPI) declined to a five-year low of 3.32 per cent in the week ending September 8, 2007. In a week in which the US Federal Reserve Board cut its benchmark rate by 50 basis points and the Sensex crossed the 16,000 mark, this is being interpreted by many as reason for the Reserve Bank of India (RBI) to follow suit and reinforce the good feeling that the Fed's action has stimulated. However, before reaching the conclusion that the domestic inflationary threat has completely receded, it is worth looking at the numbers more closely.

The three main components of the index are primary articles, which include food, energy and manufactured products. According to the latest release, the increase in the prices of primary articles was a rather high 7.45 per cent, reflecting persistent bottlenecks in domestic supply as well as global pressures on the prices of many commodities and raw materials. Within this category, food prices increased by 5.8 per cent, still in a discomfort zone and likely to reflect in a relatively high rate of consumer price inflation. The generally good rainfall during the monsoon season that is just ending might have been expected to have a positive impact on food prices, but that has apparently not happened yet. Of course, the overall supply situation will become clear by October-November, by which time prices may well moderate further. However, looking beyond this into the first half of next year, developments such as the further downgrading of estimates of the Australian wheat harvest are likely to keep expectations about global food prices relatively high in the coming months.

The main reason for the significant decline in the overall inflation rate is the behaviour of energy prices in the index. They collectively declined by 2.93 percentage points over the corresponding week last year, in clear contradiction to recent global trends. In recent weeks, the international price of crude oil has risen to its highest level ever and has given every indication of persisting at these levels, despite announcements by OPEC that its members will increase production in the coming months. Ironically, the Fed's action, by diluting fears about a possible US recession and an accompanying global slowdown, has probably provided a boost to oil prices. India has so far not responded to this recent surge, but will have to increase domestic prices at some point. An appreciating rupee will help mitigate the impact somewhat but cannot offset it entirely. In short, the deflationary pattern visible in the index is the result of the government's failure to pass on the full impact of high oil prices.

The good news on the inflation front is really with respect to the prices of manufactured goods, which increased by 4.14 per cent over the corresponding week last year. This is a definite improvement over the 6 per cent rate of increase visible for the last several months. Along with the moderate deceleration in industrial production, this pattern indicates that the monetary tightening is having the desired effect in mitigating demand pressures in the economy. Overall, then, while the RBI can draw comfort from the numbers, the food and energy scenarios indicate the possibility of resurgent inflation in the coming months. Its actions need to take them into account.