Riding out the storm

The inflation rate, as measured by the wholesale price index (WPI), almost touched 8 per cent in the week ended August 7. The last time this weekly measure crossed the 8 per cent mark was in February, 2001. The reasons for the spike are slightly different this time. In February 2001, as in the weeks preceding it, the cause was almost exclusively a large adjustment in fuel prices.

Today, while fuel prices are playing a significant role, what is striking is that both agricultural commodities and manufactured goods are also contributing substantially to the surge. The obvious sources of inflationary pressure are unquestionably external.

Oil prices have been soaring in recent weeks to new peaks. Steel prices have also been breaking records as a China-led global demand boost shows no signs of abating.

To that extent, the impact on domestic prices in India is simply a reflection of what is happening to the rest of the world. The prices of manufactured goods are rising because major inputs are getting costlier. However, there is a domestic element to the inflationary pressure as well.

Industrial capacities across a range of sectors appear to be reaching saturation. The failure of the monsoon in the first half of the season has also had its impact on the prices of several agricultural commodities. For the country's macroeconomic managers, there are clear dilemmas in the face of this combination of global and domestic pressures.

First, is the external dimension going to be temporary or persistent? More and more people are veering around to the view that the world economy should prepare itself for a serious oil shock. Similarly, China is supposed to be managing a soft landing; as that happens, demand for various commodities should decline gradually, but noticeably.

So far, the global markets don't seem to have noticed. But despite these indications, things could turn around in a few short weeks. In such a scenario, any policy actions based on the assumption that these conditions will persist could prove to be a hindrance to growth.

Second, how important are the domestic factors over which the government may actually have some control? On this score, judgments can be made with a greater degree of confidence.

The monsoon impact will prove to be short-lived as a result of the second-half recovery and the prospect of a decent rabi season. New capacities are coming up in several sectors and these should come on stream in a few months' time.

Policymakers can thus safely ignore the domestic contribution to inflation and resist the temptation to implement demand compression measures, as is being advocated in some quarters.

If it is accepted that the external contribution is predominant, then what options do policymakers have? In reality, very few. Duty cuts are logical and will have some impact, but they can only be done once or twice.

The only solutions are long-term changes to reduce energy intensity and raise productivity. This may be as good a time as any to set good policies in motion, but in the immediate future the country must simply prepare itself to ride out the storm. Of course, for the first time, we have both the foreign exchange and foodgrain cushions necessary to help minimise the discomfort.