An appropriate policy response always warrants a correct diagnosis of the problem. That is why the recent trend in inflation and its causes, and the inflation outlook take on exceptional importance ahead of the RBI’s policy review on January 25.
At the very outset, by focusing on the wholesale price index (WPI) rather than a proper consumer price index (CPI), RBI makes its own job more difficult. This is so because the WPI is inherently more sensitive than the CPI to changes in input prices. Thus, higher commodity prices, for example, have a faster and more complete pass-through to WPI than to CPI inflation. All other countries target CPI inflation, which is often lower than WPI or PPI (producer price index) inflation. It must be embarrassing for the government that, despite having several bright economists, it has not been able to come up with a proper CPI.
The web of inflationary pressures in India is more complex than in most other economies, and is both supply- and demand-side in nature, and covers both food and non-food categories. Essentially, there are six key drivers of inflation, in my view: (1) cyclical pressures as growth has been above trend; (2) higher global commodity prices, especially for crude oil; (3) the boost to aggregate demand due to the government’s active initiatives to empower rural India via employment-generative social safety net programmes; (4) slow pace of fiscal consolidation; (5) rising affluence that has increased demand for protein-rich food, which, in turn, has worsened the supply-demand imbalance owing to a lack of adequate supply response; and (6) temporary weather-related food price shocks.
There are certain other dimensions, such as pressure on the wages of manual workers as the pace of outward migration from some key states, such as Bihar, appears to have slowed. But this is a “good problem” to have. At the other extreme is the wage pressure in the IT industry that is driven by external demand. The IT example, and the lack of adequate skilled labour in other industries, also underscores the need for greater improvement in supply that is outside the focus of monetary policy. Indeed, we should stop looking at RBI for solutions to the government’s paraplegic-like approach in correcting the structural rigidities that can have a significantly favourable impact on trend inflation.
The above drivers of inflation can be grouped differently: supply- vs demand-driven; domestic vs external, cyclical vs structural, food vs non-food, and temporary vs permanent. No matter how we categorise them, monetary actions and fiscal initiatives should not work against each other. Ironically, the government’s initiatives that have actually contributed to the resilience of rural India’s consumption are also the ones that have partly contributed to the inflationary pressures, as the supply of certain food items has not increased meaningfully.
It is easily overlooked that WPI inflation had actually been improving in recent months. Headline WPI inflation had eased to 7.5 per cent y-o-y in November from 11 per cent in April, before a temporary weather-related hit to vegetables pushed up inflation in December to 8.5 per cent. After declining for ten straight months, the food composite sub-index (weighted average of food components of primary articles and manufactured goods sub-indices) jumped to 8.6 per cent y-o-y in December compared to a three-year low of 6.1 per cent in November. Non-food manufactured goods inflation, a crude measure of core inflation, was a touch softer in December at 5.3 per cent y-o-y, but this is likely to head higher owing to the pass-through into local prices of rising global commodity prices. The pace of seasonally adjusted core inflation has also picked up, with higher commodity prices accounting for a large part of the increase.
Within food, the prices of staple items such as wheat, rice and pulses (an important source of protein) are not showing distress, despite the adverse global price pattern in these items. The December spike in food inflation appears to be concentrated in fruits and vegetables (+22.8 per cent y-o-y), which, in turn, has been led by a whopping 45.8 per cent (temporary) spike in the price of onions.
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By their very nature, temporary food shocks are treated differently by central banks, as these are typically short-lived and last less than the typical lag between monetary policy action and its effect. However, a lasting food shock becomes a different animal as it then begins to affect expectations, which, in turn, can have a more permanent effect on either the headline inflation rate or some version of core inflation. Thus, central banks cannot directly affect food supply with interest rates, but monetary action cannot be avoided when a food shock threatens to have a more permanent effect.
So far, the bulk of the heavy lifting on policy normalisation has been done by RBI, which increased policy rates by 300 bps in 2010. The challenge to monetary policy becomes greater when there are also numerous supply-side drivers that complement demand-driven factors, which are what a central bank can directly affect with tighter policy. The upcoming federal Budget offers a good opportunity for the government to step up fiscal consolidation, which, in turn, should ease pressure on aggregate demand that was pumped up additionally by the extra spending following the telecom windfall.
The correct response to the supply-demand imbalance for food is higher supply, not aggressive monetary tightening that will surely derail growth at a time when the much-needed investment upturn is still in its infancy, and could itself be at risk, partly owing to poor execution by the government and rising cost of borrowing. The cyclical demand-driven pressures should ease, as growth is already rolling over, even if one discounts that the volatile industrial production data that probably exaggerate the deceleration. Further progress on fiscal consolidation will add to the softening in domestic demand-driven inflation.
However, the threat from higher global commodity prices still persists, and is one of the reasons why the pass-through into local prices will prompt RBI to tighten further, starting with a 25 bps hike and a hawkish guidance on January 25. A 50 bps hike is too aggressive in my view, and RBI had used with that magnitude when inflation was much higher and growth itself was accelerating. RBI has to raise policy rates further this year and should front-load them, but it is important to appreciate that India’s inflation challenge is not due to excessive pace of monetary expansion, as M3 growth is running close to the RBI’s guidance of 17 per cent, and there is already far greater tightness in local liquidity conditions than what RBI intends.
Since all the inflationary pressures are not from the demand side that RBI can directly address, a super-aggressive tightening will surely derail growth, and that will create an even worse combination of still high inflation, crippled growth, and a fiscal crisis.
A significant difference that is often looked between the economic conditions in 2005-08 tightening and now is the vastly weaker setting for investment spending this time around. RBI will have to be more cautious in its tightening, since the full effect of its 300 bps normalisation in 2010 has not been fully transmitted. Still, headline inflation will be higher for longer owing to rising global commodity, despite RBI’s tightening. Crippling growth to win the inflation battle should not be on the agenda, but it is high time the government wakes up and owns up its share of the responsibility.
The author is senior economist at CLSA, Singapore. The views expressed are personal