Inflation

The 1990s is widely described in general as a price stability era all over the globe. During the early part of this decade, developed and developing countries alike experienced "a distinct ebbing of inflation", so observes India's central banking authorities, the Reserve Bank of India (RBI). Inflation in India, barring some external factors like bouts of increase in international oil price and natural disasters like drought or flood, is showing an ebbing trend. To attain exchange rate stability and an smoother and higher trade with the country's major trade partners in developed countries in particular, it is imperative for India to be around the inflation rate ruling in its trade partner-countries. Compared with early 1990s, inflation in India has ebbed to a marked extent and ruling in the range of 4.5 - 5.5 percent compared with double digit inflation in some early years of 1990s.

Spiralling food and commodity prices pushed the inflation rate to a worrisome 7 per cent and the concerned government, confronted with major supply constraints, threatened to come down heavily on hoarders. The latest price data showed that the Wholesale Price Index (WPI) has reached its highest since December 2004. The rate of inflation in the previous week was 6.68 per cent and 6.54 per cent in the corresponding week a year-ago. The Centre has already empowered state governments to impose stock limit orders on essential commodities to check hoarding. Earlier this week, the government announced a slew of measures, including import duty cuts on edible oils and a ban on export of non-basmati rice. Experts cautioned that the price situation was unlikely to ease in the near future as a shortage of food had pervaded the world economy. Record prices of rice and sky-high oil have stirred up inflation worldwide, prompting many governments to impose price controls and curb exports of essential goods. The mineral category index shot up by 38.2 per cent, primarily driven by a 46 per cent rise in the prices of iron ore. Inflation is in an accelerating mode and we are yet to see any signs of its softening.

The RBI will announce its slack-season monetary policy this month and many analysts expect the central bank to raise interest rates to tame inflation. The present inflationary spiral is a pure supply-side phenomenon and not due to overheating in the economy. India’s gross domestic product (GDP) is estimated to grow at a slower 8.7 per cent in 2007-08, after clocking 9.6 per cent in the previous year. Your monthly expenditure will go up, your groceries will cost more and your disposable income will buy less for the same money. Retailers will pass on the rise in wholesale prices to consumers. Your home loan rates may shoot up. The Reserve Bank will take steps to tighten money supply. This will either stop interest rates from falling - or could even make them rise to curtail overall demand in the economy. Your salary hikes may be curtailed. When inflation goes up, your employer’s costs go up and to save money the employer may reduce or hold back your pay increases Growth may slow - and so will job prospects. Industries put their foot on the brakes or accelerators when interest rates go up. They hire fewer people or take their time to make up their minds on investment plans. This could stagger job prospects. Your stocks and mutual fund values suffer. It is simple; when economic growth suffers, corporate earnings take a knock and bulls and foreign investors stay away from the market. Exports may be hit. If inflation goes up, the cost of manufacturing goods or producing services like software in the country goes up. The country’s competitiveness may suffer as a result and export sector prospects in industries like textiles, software and jewellery may be hurt. Imports will become costlier if the rupee becomes weaker. That makes the government’s oil bill higher, and this could potentially lead to increased fuel prices are in diesel, cooking gas or kerosene. And foreign trips will become tougher as well.

The sharp rise in wholesale price index based inflation to 6.68 per cent, no doubt, calls for a response from the government. It is important that the government analyse the causes of inflation before proposing a response. Last year too, about the same time, inflation had risen sharply. This was brought down by an increase in interest rates. But last year, inflation was demand driven and the rate hike helped in cooling down the overheated Indian economy. Growth slowed down, as expected, and price rise was contained. This year’s inflation is different. It is coming at a time when the economy is slowing down. The strategy to reduce inflation cannot be based on reducing growth further. This year’s inflation is primarily the result of a supply shock coming from rising world commodity, food and oil prices. It would be a mistake to raise interest rates to deal with this kind of inflation. Growth would slow down further and, given that inflation is due to higher global prices, it may not be significantly contained. The best way to deal with international price inflation affecting the Indian economy would be a strong rupee. The exchange rate pass-through from a change in the rupee-dollar rates to domestic inflation is positive. In other words, when the rupee appreciates it reduces the price of imported goods or import parity priced goods, that is, goods whose prices are determined by world prices. This will help in pulling down prices. Instead of quantitative restrictions such as a ban on exports of food products whose world price is high, a strong rupee will ensure that it is less profitable to export these items. This will help make more food available domestically. Also, it will make it cheaper to import food and food products. The government should, in addition, eliminate import duties on edible oil, for example, to make it more affordable. The combination of a strong rupee and the removal of duty will make food products cheaper. It will also eliminate incentives to hoard.

One of the most serious policy mistakes made by the UPA government over the last year was to prevent the Indian consumer from benefiting from a strong rupee. The political power of exporters appears to have forced the government to resist rupee appreciation. Since rupee appreciation comes at the cost of higher domestic prices, today, the government is paying this price. Hopefully, now that we are closer to an election, the interest of the larger mass of the population may rule over the interest of a concentrated group of exporters.