Find appropriate responses

Inflation has emerged as the dominant macro-economic problem of the day, overshadowing another equally negative development, the slowdown in industrial production. For the week ending March 15, the (provisional) Wholesale Price Index recorded an increase of 6.68 per cent over the corresponding week of 2007. The inflation rate last year was also a relatively high 6.56 per cent, so the effect of a low base cannot be blamed for the latest number. Indeed, given that the final index numbers are usually revised upwards from the provisional numbers, the inflation rate may well have crossed 7 per cent by now. That is certain to raise the political temperature, with the opposition and Left parties intending to escalate their confrontation with the government over the issue. Government representatives have been on the defensive. Some responses have already been initiated: lowering of import duties on edible oils and, more recently, export restrictions on various commodities, for example. Opinions have also been expressed about an interest rate hike by the Reserve Bank of India.

The question is whether these are the appropriate responses. For, while food prices have certainly contributed in recent weeks to inflation, the most recent surge is not particularly attributable to food. Perhaps the government has been prompted by the political sensitiveness of food prices. But it so happens that the major contributors to the present price rise have been non-food primary articles (whose prices have spurted by 14.6 per cent, compared to a year ago) and basic metals and alloys (which have clocked a whopping 22.9 per cent rise), whereas much of the anti-inflationary action has been focused on food products that have become dearer by a relatively meagre 8.2 per cent. It is no surprise, therefore, that none of the three major moves made recently have had any perceptible impact on prices.

Take the duty reduction on palm oil. As on so many occasions in the past, the duty cut was greeted by the palm oil exporting countries immediately hiking their export prices and export taxes; the advantage of India's duty cut has therefore gone to the farmers in those countries, not to Indian consumers. The ban on edible oil exports, on the other hand, is meaningless as such exports total only 10,000-12,000 tonnes of branded oils in small packs that cater to ethnic Indian populations abroad; against this, the annual edible oil imports total nearly 5 million tonnes. Similarly, the impact of the DEPB benefit withdrawal on domestic availability and prices is expected to be marginal. But even as these measures have proved ineffective, what the government can take heart from is the fact that wheat prices in the domestic market have already started moderating as the rabi harvest season sets in.

The surge in iron and steel prices (which probably lead the inflation table just now) reflects global market conditions; the issue is whether these conditions will persist or change. The outlook for global growth during the year ahead has become relatively pessimistic. China, which has such a powerful influence on commodity prices, is taking firm steps to cool its economy. In addition, there is the impact that the US slowdown will have. Under these circumstances, commodity prices could well moderate in the short term. This supports the argument that macro-economic policy should not respond in conventional ways to inflation rates that are disproportionately influenced by individual commodities, particularly if these developments are going to be short-lived. This, of course, leads to the broader question of whether inflation is being correctly measured by the current indices and whether the country needs to move to a more sophisticated measure of "core" inflation, which is not as sensitive to specific commodity prices.

The problem in a pre-election period is that, even more than an economic problem, inflation becomes a political challenge. This prompts policy responses that affect growth, without much heed being paid to that cost, while the desired effect on prices is not there. Thus, the Reserve Bank may be prodded to tighten its monetary policy stance, and there is already speculation that the cash reserve ratio may be raised in order to mop up liquidity (which will raise the cost of money and therefore slow down spending). Another possible response would be to encourage the rupee to rise against other currencies, as that would make imports cheaper and therefore act as an anti-inflationary measure "" indeed, whether coincidentally or because of RBI actions, the rupee has once again crossed the Rs 40 mark against the dollar. However, the price for a stronger rupee will be paid by exporters who have already been affected by the 12 per cent rise of the rupee against the dollar over the past year. A good indication of the policy response might come when the extent of the industrial slowdown becomes known with the release of the industrial production numbers for February, on April 12. If those numbers are discouraging, the RBI will face the difficult challenge of tackling a slackening of growth while also coping with a rising inflation curve that is driven by non-monetary factors. But as already noted, in political terms the emphasis is almost certainly likely to come down on the side of emphasising inflation control. The question is what role monetary policy gets in the overall policy response.

Meanwhile, having failed to make impact with its initial burst of anti-inflation measures, the government seems to be thinking of letting the ordinance to amend the Forward Contracts Act lapse. The statute, as amended through the ordinance, seeks to impart badly needed autonomy to the Forward Markets Commission and to allow options trading in commodities. What the government seems to be overlooking while deciding against retaining this important amendment is the fact, established fairly conclusively by now, that futures trading has not been responsible for the price rise in agricultural and other commodities. Though the report of the Abhijit Sen committee, which is probing the link between price escalation and futures trading, is not out as yet, indications given out by the committee discount the hypothesis that futures trading has triggered the price rise. In fact, what is required is to strengthen the forward markets regulator, as sought to be done through this ordinance. Equally important, futures trading is incomplete without options trading, which is not yet permitted on the commodities exchanges "" a lacuna that the amended law seeks to remove. Indeed, options trading enables farmers (read commodity producers) to hedge their price risks by giving them the right, without the obligation, to sell their produce at the quoted prices. By doing so, it helps the futures market to serve as an effective tool of price discovery and price stability. While figuring out what else needs to be done about inflation (and it is obvious that more anti-inflation measures are in the works), the government must revisit its anti-inflation strategy.