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The scourge of relentless inflation September 7, 2010

Posted by southasiamasala in : India, Jha, Raghbendra , trackback

Raghbendra Jha and Raghav Gaiha

Inflation has been in the news for some time.  Recent media reports have come to the view that the RBI deems current inflation to be a scourge. This inflation has also been relentless. There seems to be broad consensus among analysts that the current spate of inflation had its roots in food price inflation.  Last year’s drought led to steep rises in retail food prices followed by hikes in procurement prices for farmers.  With a strengthening of the effects of the drought foodgrains had to be imported on a large scale, at prices higher than were being paid to Indian farmers.  This then led to a further round of increase in the prices paid to farmers and an inflationary spiral set in.  More recently, however, clear signs have emerged that inflation in the non-food sector has picked up even as food sector inflation has moderated somewhat (although still in the double digits), capacity constraints have been hit and inflationary expectations have become entrenched.

It is against this background that anti-inflation policy must operate.  In this article we want to make a couple of points about the current policy debate about inflation.

First, unlike what is being said in some quarters, supply shocks are still reverberating through the economy.   The initial supply shock came from the food sector, followed by the rise in prices of petroleum products, whereas the recurring supply side shock now is from rising expected inflation.  The higher the rate of expected inflation the lower will be the gap between actual and expected inflation and the smaller the resulting (positive) deviation of output from trend.  It is in this context that combating supply side shocks becomes a quintessential element of anti-inflation policy.  We are all agreed that a good kharif harvest from a good monsoon might translate into a positive supply shock and lower inflationary expectations. However, such a positive outcome might be limited to being a seasonal phenomenon if food supply chains are not well managed.  It is in this context that one reads reports of waste of existing foodgrain stocks in Food Corporation of India godowns.  Putting a firm stop to this will not come a day too soon.  More coordinated and timely distribution of such grain would also be welcome.  These comments extend beyond foodgrains to many perishable items like vegetables and milk, large quantities of which are wasted because of the paucity of effective storage. Merely reducing demand against the background of recurring adverse supply shocks will, other things remaining unchanged, only lower output growth without having a substantial impact on inflation. The bottom line here is that without tackling supply side constraints there can be no easy victory in the fight against inflation.

Second, while WPI and CPI inflation are statistically linked there are enough (mutually independent) factors affecting the two that causal links between the two can become tenuous.  In this context one has to be clear about the quantitative impact and time profile of the impact of policy rates on various measures of inflation.  The empirical evidence of such impacts, particularly on the CPI, is not encouraging. A recent paper (Jha, R. “Inflation Targeting in India: Issues and Prospects” International Review of Applied Economics, vol. 22, no.2, March 2008) has demonstrated that the mean impact of the call money rate on CPI is uncertain, subject to long lags and the overall impact has a wide 95 percent confidence interval.  The extant literature has accepted that there are several reasons why interest rates may not have a straightforward relation with CPI in the context of a country like India.  These reasons include limited independence of RBI, substantial fiscal overhang, the frequent need by the RBI to resort to other nominal anchors, and the predominance of supply as opposed to demand shocks. Even in developed market economies inflation targeting is facing opposition for excluding asset prices from CPI and because of the need to monitor other nominal magnitudes such as exchange rates (Kirsanova, T., Leith, C. & S. Wren-Lewis [2006] ‘Should central banks target consumer prices or the exchange rate?’ The Economic Journal, Vol. 116, F208-F231). There is thus urgent need to understand more fully the impact of policy rates in particular and macroeconomic policy in general on inflation.

In the current milieu anti-inflation policy will work only if it is cognizant of the forces that initiate and sustain such inflation, i.e., by tackling supply side issues.  Further, expansion of demand from rising fiscal expenditures must be restrained.  Merely raising interest rates will not help. The current round of inflation in India is certainly a scourge.  The longer it is allowed to run its course the more devastating and deep will be its impact on the economy and society.  Stabilizing prices will not only have positive macroeconomic impacts but also enhance human nutrition outcomes, thereby impacting positively on productivity and resulting in a favorable supply shock.

Raghbendra Jha is Professor of Economics at Australian National University, Canberra (contactable at r.jha@anu.edu.au); Raghav Gaiha is a Visiting Scholar at Department of Urban Studies and Planning, MIT, Cambridge, MA 02139, and a Professor of Public Policy, faculty of Management Studies, University of Delhi.

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