Recurrent inflationary pressures have also constrained India's sovereign rating as they keep domestic capital costs high; erode domestic purchasing power as well as savings and lower international competitiveness.
Gap between food demand and supply fuels price pressures
Food inflation in India is much higher than the global average. It is a key contributor to India's overall inflation, as food comprises a significant portion of the average consumer basket.
India's large, young population and rising wages among low earners who spend most of their incomes on food have raised demand for food. However, the supply response has been weak due to poor irrigation and rural infrastructure, sub-optimal fertilizer use, and conversion of agricultural land to alternative uses. Inefficiencies in the government-directed food distribution system have exacerbated food supply constraints.
Inflation trends will depend on policies to address agricultural supply issues
Indian authorities recognize that the current recovery will be difficult to sustain if inflation persists. They have announced several measures to curtail food price pressures. These include greater food-price monitoring by state governments, a stabilization fund to lower market prices, and harsher penalties for hoarders. While these policies may alleviate the food-price spikes stemming from lower food output due to this year's relatively weak monsoon, they do not address the long term widening of the gap between food demand and supply.
Whether this gap is bridged will depend on the implementation of government plans to increase spending on rural infrastructure, re-orient fertilizer subsidies to encourage optimal usage, and restructure the Food Corporation of India, which is responsible for executing the government's foodgrain procurement and storage operations.
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However, the authorities have yet to set out concrete plans vis-vis certain other major constraints on supply. For instance, it is hard to see how significant private investment in cold storage facilities will be, if current restrictions on foreign direct investment in the retail sector remain in place. It is also not clear whether officials will substitute the previous practice of ad-hoc trade bans on food items with a medium-term trade policy that would enhance predictability in food supply.
Risk of inflation spreading is high as growth accelerates
The central government's efforts to implement effective supply-side policies may be complicated by the intricate nature of current agricultural market practices and the fact that agriculture is a state-level subject in India's federal system.
But if the gap between food demand and supply does not narrow, food costs will keep mounting. And as growth picks up, the increasing cost of food could more quickly feed into rising wages, leading eventually to higher non-food inflation as well. In the absence of a significant increase in food output, the risk that inflation could limit India's growth prospects remains salient.
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