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India's experiments with inflation

May 15, 2008 15:19 IST

American economist Alan Blinder once said: "Price stability is when ordinary people stop talking and worrying about inflation."

With inflationary pressures predicted to stay in India this year, the greatest concern for the Union government is to take appropriate measures to combat inflation. A steep rise in food prices will make inflation control more difficult, Prime Minister Manmohan Singh said and he urged the global community to act together to ease a supply-demand mismatch.

Opposition politicians have pounced on the figures, which are seen as deeply embarrassing for the Indian government. Ruling politicians in India have a wise regard for the onion, which on occasions has proved as potent enough for removing governments.

Controlling inflation is a pre-requisite for winning elections in the country although that alone is not sure to guarantee success. In 1998, a coalition led by the Bharatiya Janata Party (BJP) was defeated in a Delhi state election after a six-fold rise in onion prices.

In 1996, when inflation was far below the levels in 1991, Congress lost the elections to Lok Sabha. Even as global rating agency Standard and Poor's opined that India's growth story to continue, it will not be immune from the slowdown of the US economy and global credit crunch.

Anti-inflationary measures

With inflation rising at its fastest rate, the Union government was prompted to reduce import duties on edible oils even as Reserve Bank of India is expected to bring in tighter monetary policies to combat the rising inflation rate. In an effort to temper price rises, the government has already cut import duties on edible oils and banned the export of pulses and most types of rice.

The government has also leaned heavily on steel manufacturers, pressing them into making "voluntary" price cuts or risk mandatory price caps.

Govindbhai Patel, Dipak Enterprises, Gujarat, a leading edible oils trader, said reduction in import duties on edible oil and fall in international prices had brought down the prices of edible oil by as much as Rs 6-8 per kg.

However, the weightage of edible oils in the Wholesale Price Index is only 2.7 per cent and only to that extent the decline in edible oil prices will be reflected in the inflation figures. Patel said that India is dependent on 45-50 per cent of its edible oil requirements through imports.

However, since the weightage of edible oils in WPI index is only 2.5 per cent and with steel, metals , crude oil prices, commodity prices ruling high, it will not be reflected in the inflation rates.

Yoginder Alagh, former Union minister and Planning Commission member, said the policy of targeting individual commodities to combat inflation is a wrong measure. He said that inflation should be treated through macro-economic measures and not through micro-economic initiatives.

Tinkering with commodity prices would only hurt some producers. On the other hand appropriate changes in trade policy and tariff policies pursued by the government is good enough.

Alagh said there are no tie-ups of output and investment targets and market economy got eroded due to poor supply side planning. "Capital formation has gone down in agriculture. What is required is fiscal policies to combat inflation and economy level controls. Monetary policy has any way been proved to be weak in combating inflation," he said.

On the food supply shortage, the prime minister recently said: "We are once again faced with a situation where rising demand for foodgrains and other food items is running into supply constraints both domestically as well as internationally. This is a phenomenon, I believe, that is not unique to India. Similar pressures are being felt across the world in many other countries."

Targetted inflation

Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or 'target', inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.

Because interest rates and the inflation rate tend to be inversely related, the likely moves of the central bank to raise or lower interest rates become more transparent under the policy of inflation targeting.

Inflation targetting was pioneered in New Zealand in 1990, and is now also in use by the United Kingdom, Canada, Australia, South Korea, Egypt, South Africa and Brazil, among other countries, and there is some empirical evidence that it does what its advocates claim.

"Performance over the six years since the bank became independent has been impressive. Against the target of 2.5% for RPIX which ran from 1997 until December 2003, average inflation was 2.4%. For 68 out of the 79 months, inflation was within 0.5 per cent of the target below it for 42 months, above it for 30, and on target for the remaining seven. Notwithstanding the stock market crash and the slowdown in world activity, the UK economy has continued to grow steadily and employment has remained strong. On a longer term view, the decade of inflation targeting since 1992 looks remarkably stable by post-war standards," according to Rachel Lomax, deputy governor of the Bank of England in a speech delivered in 2004.

Inflation targeting, a monetary-policy strategy that was introduced in New Zealand in 1990, has been very successful, and as of 2007 had been adopted by more than 20 industrialised and non-industrialized countries.

It is characterized by (a) an announced numerical inflation target, (b) an implementation of monetary policy that gives a major role to an inflation forecast (c) and a high degree of transparency and accountability, according to Lars E O Svensson, Princeton University.

In practice, inflation targeting is never 'strict' but always 'flexible' in the sense that all inflation-targeting central banks ('central bank' is used as the generic name for monetary authority) not only aim at stabilizing inflation around the inflation target but also put some weight on stabilizing the real economy, for instance, implicitly or explicitly stabilizing a measure of resource utilization such as the output gap between actual output and 'potential' output.

Thus, the 'target variables' of the central bank include not only inflation but other variables as well, such as the output gap, Svensson adds. With the success of inflation targeting in so many countries, can India also look towards adopting this model and keep our inflation rates low but keeping growth rates at optimum levels?

Is this inflation different?

Is the inflation in India any different from what it has experienced before or different from what countries like China? Yoginder Alagh said that what India is facing now is similar to what has been experienced before but compared to China our crisis is different. China has not opened up their economy and it is still not transparent.

Far better off than Zimbabwe

Inflation in Zimbabwe has crossed the one-lakh mark and it is setting newer records and government authorities announced the introduction of the new $50 million bank note. The new Zimbabwe $50 million note is worth $1 at the widely used black market trading and can buy just three loaves of bread. But can India be complacent that inflation is still below the two-digit mark.

That was what the Congress party felt when it came out in full support of the government and argued that inflation is a global phenomenon and India should not be overly frightened about rising prices. Congress media department chairman M Veerappa Moily cited China's example.

"In China, the inflation is at a 12-year high. China's inflation rate of 8.7 per cent for February this year has been its highest in the last 12 years with the country witnessing a "staggering" rise in pork and vegetable prices," he said.

But there are others who see India's inflation to be different from what other countries are facing. For example, our growth rates coupled with supply side bottlenecks are quite unique to India alone. International news magazine, The Economist, had warned in November 2006 that India's growth rate could not be sustainable unlike China and that Indian economy was overheating.

More recently, the Centre for Monitoring of Indian Economy (CMIE) had estimated in September that growth would be robust at 9.1 per cent for 2007-08. However, it had cautioned that "while fresh investments continue to flow in, slowdown in the production growth of consumer durables and decline in personal loan disbursement by banks raise questions over the sustainability of the consumer expenditure growth in future."

Yet even without significant reform, India's economy has performed so well that it is overheating. The Reserve Bank of India must control inflation if growth is to be sustained. Barring a terrible crash, by 2025 the country could have more than 580 million middle-class consumers, The Economist had commented.

Futures ban

Whenever there are price increases or volatility in any commodity, in India it is natural to demand ban of Futures trading in those commodities. However, there is no conclusive evidence that Futures market does lead to price volatilities or inflation. Banning Futures trading would do little to curb prices, especially for commodities like edible oils that are heavily imported.

Monetary policy

Speculations as to whether RBI will increase CRR rates and interest rates have been going around just as inflation breached the 5.5 per cent mark. RBI deputy governor Rakesh Mohan has hinted that the apex bank has sufficient policy measures in the pipeline.

Commodity Online