The persistent decline in the rate of inflation is the combined effect of a restrictive monetary policy, contractionary fiscal policy, a distinct slowdown in industrial growth and the absence of cost push factors since decisions on administered prices have been delayed. With a petroleum price increase clearly imminent, the rate of inflation will see an overnight spurt, but the trend rate of inflation will not change over time because of the macro-economic climate. The slack industrial growth has meant that there are no demand-induced pressures on industrial prices, while the restrictive monetary policy followed last year has ruled out the classical reason for prices rising -- too much money chasing too few goods. On the contrary, money was tight to the extent of dampening whatever sectoral demand-pull pressures may have existed.
But a whole set of prices in the Indian economy are formed in the commodity producing sectors. Out of the 447 commodities in the wholesale price index, 334 are manufactured products where cost-push factors originate from price changes in raw materials, imported cost of inputs, budgetary levies and administered prices. As such the primary causes of inflation in these commodities are in the non-monetary sphere.
The ominously high real rate of interest, which prevailed throughout last year after a virtual credit starvation of the economy, has softened now. This is affecting everything from the holding cost of inventories to the cost of fixed investment. The budget, on its part, has restructured and lowered indirect taxes, and this has had a sobering impact on prices. Where there has been some increase in input costs, downstream industry has usually absorbed these in the face of slack demand. But more importantly, the overall rate of inflation has been suppressed by not increasing administered prices, especially that of petroleum products.
While a low rate of inflation is always welcome, a rate of less than 4 per cent in the current macro-economic situation suggests underlying problems. Also, such a low level of inflation will adversely affect the fiscal balance, since revenue buoyancy is generally lower than the price elasticity of expenditure. The net result could be an increase in the fiscal deficit, which is already under some pressure.
More importantly, the economy is getting ready to emerge from two difficult years. Industrial recovery will be helped by a marginally higher rate of inflation. The encouraging sign, when one looks at the demand scenario, is that even though the overall rate of inflation is declining, the prices of manufacturing products have started firming up. The ideal way to use the current period of low inflation is by taking the overdue decision, expected any day now, to increase petroleum prices. As happened last year, such a hike will be well absorbed by the system and will not cause an inflationary spiral. It will, if anything, help the government achieve its macro-balance.
