Price pains

The inflation rate, as measured by the Wholesale Price Index (WPI), crossed the 6 per cent mark during the week ending January 6. This is the first time in two years that it has gone above that mark. However, inflation as measured by the Consumer Price Index (CPI) has been well above that for some time now. This development will clearly evoke a sharp response, most likely in the form of a repo rate hike in the quarterly monetary policy announcement due at the end of this month. Beyond the predictable policy actions, a number of questions arise, answers to which are critical in understanding the causes of this spurt and what could be done to deal with it""over and above what has been done so far.

The main reason for CPI inflation crossing the 7 per cent mark is that food prices have been increasing at rates unprecedented in recent years. Although food items account for a much smaller proportion of the WPI, their impact is clearly beginning to be felt. Over the last several weeks, the finance ministry has been pointing to the role of food prices in driving up inflation. The only way to deal with this source of pressure on prices is to quickly increase the supply of food items. This can be done either by imports or from storage. The feasibility of the former depends on the international market conditions prevailing for specific food items, and relief may be available for some commodities. The contribution of the latter depends on the availability of storage and preservation capacity and, on that front, the country is sadly lacking. This is not a problem that can be solved by tinkering with the repo rate. It needs a policy environment that will induce commercially viable investments, an aspiration that has been articulated often but acted upon infrequently.

In any case, food items are not the only cause of the inflationary pressure. The prices of manufactured goods have also been rising at faster rates, and here the evidence suggests that the existing production capacities are being stretched. This translates into demand-pull inflation, consistent with the "overheating" diagnosis which many people have put on the current growth-inflation scenario. A restrictive monetary policy is an appropriate response to this cause of inflation. Considering that the RBI has been in an anti-inflation mode since October 2004, the question is: why have over two years of tight monetary policy not had any apparent impact on inflation, even allowing for transmission lags of 12-18 months? An answer to this was provided by the RBI last month, when it opted to return to quantitative instruments with a hike in the cash reserve ratio (CRR). In doing this, it acknowledged that controlling liquidity through the repo rate was proving to be difficult because large capital inflow had emerged as an alternative source of liquidity for the banking system. In other words, two years worth of repo rate hikes, while appropriate, have been inadequate. This opens up a fresh debate on the conduct of monetary policy, which has been given a new dimension with the government's decision to eliminate the 25 per cent floor on the statutory liquidity ratio (SLR). That is all very well from a medium-term perspective, but in the immediate context a comprehensive approach to deal with both food and non-food inflation, using all feasible instruments, needs to be quickly worked out.