Subir Gokarn: The elusive soft landing

Macroeconomic management is still vulnerable to the frailties of our agricultural sector.

Last week's announcement on the inflation rate for the week ending January 27, 2007, estimated it to be 6.58 per cent, the highest in two years. The government is under increasing pressure to do something beyond the ordinary to rein it in. But, while many options appear both feasible and potentially effective, there needs to be clear understanding of what is causing this spurt and why the measures that have been taken so far don't seem to have worked.

An obvious cause for concern is the apparent ineffectiveness of monetary policy, which has been in inflation-fighting mode since October 2004, when the Reserve Bank of India (RBI) raised both its benchmark reverse repo rate and the cash reserve ratio (CRR), in response to the very sharp spike in the inflation rate a few weeks before. A number of rate hikes and one CRR increase later, the inflation rate continues its merry way, seemingly oblivious to the efforts of the RBI to check it. This raises the question: does the nature and intensity of monetary responses need to change in order to curb inflation?

But, there are questions beyond this one. Is the current inflationary pattern directly related to the prevailing monetary situation? Or, is it more the consequence of demand-supply mis-matches in a set of commodities, which, because of their combined weighting in the Wholesale Price Index (WPI), is translating into a significant impact on the increase in the index value and, hence, the inflation rate? If this is the case, the solution lies outside the monetary framework. Rapid increases in the supply of the relevant commodities are the best way to deal with this phenomenon.

So, how did we get to the 6.58 per cent mark? Food articles were the primary reason. They showed a year-on-year increase of 9.97 per cent. To put things into historical perspective, this category experienced an annual rate of increase of 5.79 per cent between January 1994 and January 2006. Of course, there were ups and downs in the rate during that period, but the fact that the rate of increase in wholesale food prices during the last year was over four percentage points higher than its average of the previous 12 years certainly points to serious disruptions in the supply situation of food articles.

This is not to say that food items were the only culprits. The prices of manufactured goods increased 6.21 per cent over the last year. By comparison, they increased at an annual rate of 4.56 per cent during the previous 12 years. There has clearly been acceleration during the last 12 months, but nowhere near as dramatic as in the case of food articles. In contrast with these two categories, energy sources, whose prices increased at an annual rate of 9.91 per cent during 1994-2006, most of this coming after 2003, decelerated to a rate of 3.67 per cent during the past 12 months.

While the increase in food prices is unmistakably due to supply constraints, the increase in the prices of manufactured goods is a little more difficult to pin down. One would have to examine the pattern of relative changes across different goods within this category. However, on the face of it, the gradual upswing from the long-period average is more indicative of a more or less uniformly spread increase, consistent with rising demand and stretched capacities. In effect, we have two entirely different drivers of price increases complementing each other to take the observed rate to the 6.5 per cent mark.

What is the appropriate policy response? To the extent that some of the observed increase in prices is attributable to demand pressures, the anti-inflationary monetary stance is certainly a valid one. In the current supercharged situation, a 25 basis point hike in the repo rate may appear to be little more than a token response, but if we do take the rate of increase in the prices of manufactured goods rather than the overall rate of inflation as the indication of demand pressures, it seems entirely reasonable.

Of course, for the repo rate hike to be effective, it has to transmit itself through the banking system and financial markets to take all interest rates higher. This will not happen if banks do not need to borrow funds from the RBI in order to meet reserve requirements. The continuing momentum of capital inflow from abroad has, in effect, provided banks an alternative source of liquidity with which to meet these requirements. The repo rate hike has to be complemented with measures to absorb liquidity, so that it does become a binding constraint on the banks' willingness to borrow to accommodate rapid expansion of credit. This was done in December and, is very likely to be done after the Budget estimates of government borrowing requirements for the year are known.

But, all this does not address the supply constraints that are causing food prices to shoot up at rates far above the long-period average. Some of this is bound to moderate as fresh crops come into the market, but there are also structural factors at work, which do not suggest alleviation of the pressures in the near future. The RBI Governor's statement on the occasion of the quarterly review of monetary policy on January 31 pointed to global constraints on the availability of major food items, which render imports ineffective as a solution. Domestic policy reforms designed to improve the supply situation will certainly not yield dividends in a hurry.

So, is there a solution to this? There really don't seem to be too many options available in the short run. Over time, the share of food items in the consumption basket of even lower income households will decrease, thereby reducing the political significance of food prices. But, that is clearly no consolation for the government today. Improvements in the supply situation, both domestic and global, are really the only enduring solution. Immediate relief will, of course, come in the form of good harvests of some crops.

If anything, this episode demonstrates that macroeconomic management is still vulnerable to the frailties of our agricultural sector. Apart from all the other arguments in favour of radical reforms in agriculture, here is one more.

The author is chief economist, Crisil. The views here are personal