Why is the government losing the battle against inflation? The stock answer, at least from the inflation hawks, is that the Reserve Bank of India (RBI) has fallen seriously “behind the curve” in raising rates. I don’t entirely buy this argument — it appears a little too pat and simplistic. I doubt if a half percentage point increase instead of a quarter in the last couple of monetary policies would have made that big a dent in either the headline number or inflation expectations. The answer, perhaps, is far more complex.
Why? A number of things appear to have changed in the economy over the last couple of years which has altered the relationship between prices and other macroeconomic variables. I guess one could describe these changes as “structural”. I am not sure whether either our analysis of inflation or the strategy of managing it has paid adequate attention to these issues. The government’s response has been to see the price problem essentially as a supply-side problem of the agricultural sector that could be tackled through short-term measures. The RBI’s approach, on the other hand, has been to treat the episode as a cyclic phenomenon that it hopes will respond to the textbook cure of higher rates and tighter liquidity. Neither seems to have worked. The RBI has had to face the embarrassment of revising its March 2011 inflation forecast thrice all the way up from 5.5 per cent to now 8 per cent. It is possible that with a diesel price rise, inflation will be close to 9 per cent by August.
Let me get to the point. The biggest “structural” transformation that some of us in the profession have been noticing is in the unorganised labour market. Over the last two or three years, wages of relatively unskilled workers seem to have grown exponentially and there appears to be a major supply deficit of labour in sectors like construction. The evidence is mostly anecdotal so I have no hard numbers to share. However, I can bet that a brief conversation with a building contractor in the country will corroborate what I am saying. My colleagues from our bank’s rural branches in Punjab and Uttar Pradesh tell me that bigger farmers who use seasonal contract labour have faced similar shortages.
A large proportion of unskilled workers constitutes migrant workers in north India drawn from the poorer agricultural states like Bihar, eastern Uttar Pradesh and now West Bengal. Thus, this supply shortage, prima facie, suggests that the migration rate has declined. That, in turn, suggests that rural income levels have improved and so have employment opportunities. It would again be a little too simplistic to attribute everything to the National Rural Employment Guarantee Act or to the sharp increases in food procurement prices. However, it is reasonable to assume that both factors have played a role in keeping workers back in the rural economy. The bottom line is that the elasticity of labour supply has dwindled quite sharply. The economy seems to have moved quite rapidly from a Lewis-model world of an infinitely elastic supply of labour available at low wages to one in which critical sectors of the economy are facing serious labour shortages.
One could argue that labour shortage is hardly a new problem. High end-services such as IT and banking ran against a binding constraint when they heated up in 2006 and 2007. The global financial crisis cooled things down a bit. Otherwise, inflation pressures would have built up much earlier. Now the problem has cropped up in the market for low-skilled labour and that is beginning to impinge on sectors like infrastructure and house construction. The corollary of this labour shortage is rapid wage escalation, which, in turn, feeds inflation. Of course, there are nuances. Wage escalation has gone hand in hand with a shift in dietary preferences. The result has been that price pressures have been felt most sharply for items like meat, milk and vegetables in which supply bottlenecks have been the most acute.
What are the implications? For one, it is important to simply recognise that in the face of such a rapid transformation, conventional tools of monetary policy could be somewhat limited in their effectiveness. One way to interpret the RBI’s reticence in responding more aggressively to over-target inflation is to see this as a tacit recognition of this (perhaps it hasn’t gone as much by the textbook after all). If we read RBI Governor Subbarao’s lips carefully, he might just be trying to tell us that we may need to reconcile to a phase of elevated inflation. The degree of price elevation will depend on the kind of demand pressures that exist in the system. Demand pressures depend on growth and unless growth comes down palpably, wage pressures will continue to feed inflation. Thus, instead of endlessly fretting over the fact that growth is slowing, we need to accept slower growth as being necessary to cool prices off.
In the current situation, I would rely more on the massive fiscal compression that the Budget 2011 seems to aim for to slow down growth than on monetary policy. I assume, of course, that the finance minister doesn’t go way over his targets. Apart from hitting growth directly, it could simultaneously slow down the pace of cash flow to the rural sector and bring about some correction in the labour market.
Viewing inflation in the context of imbalances in the labour market might not throw up a quick fix, but it should help in identifying the right issues in the long haul of the war against inflation. From a policy perspective, we need to focus on the massive disequilibrium in the labour market, which is starkly visible only if we care to look. We need to find the right balance between short-term payoffs from public works programmes in the rural sector and the necessity of creating sustainable manufacturing-driven jobs. Otherwise, we might find ourselves snared in a trap of persistently high inflation, low productivity and a permanent drag on growth.
The author is chief economist, HDFC Bank
