THE PRICE CONNECTION - TRACKING THE FOOTPRINTS OF INFLATION

If you like reading newspapers, chances are, you already know a lot about how hard the Reserve Bank is trying to rein the inflation menace. RBI persistently hiked policy rates (Repo) – 12 times, in the last 23 months, although it had negligible effect on inflation beyond a certain point . Unlike other parts of the globe which are now seeing a dip in price levels, inflation in India has remained  surprisingly high. And since Indian economy has become fairly integrated with the world economy , this non-conformity with a global trend is being viewed by investors and policy makers as an anomaly, which might lead to bigger problems in future.

RBI has had a pretty straight forward solution for dealing with this problem - increase interest rates to absorb excess liquidity from the system. With no extra money chasing goods, it reasoned that the demand-supply balance will be restored, thus bringing down price levels. For example, a persons spending capacity is hit to the extent of increased charges on his credit card, increased EMI on his housing/car loan or a likelihood of lower bonus / uncertain employment scenario (his company has debts too) etc. resulting from hike in interest rates and therefore demand is weakened. It takes time for supply to correct and achieve the new optimal level of output (lower) necessary for maintaining the prevailing price level, hence price correction ensues.

Now, many will feel that by hiking interest rates, RBI played its part pretty well in managing the economy. It helps that inflation did come down from its peak levels of 16% (January 2010) to about 10% in January 2011 after a series of interest rate hikes were brought into effect by RBI. But here’s something very interesting, interest rates were raised 5 times in 2010 by a total 300 bps (1 bps = 1/100^th of a percent), the resulting impact on inflation was a decline of whopping 650 bps. But in 2011, interest rates were again raised on 7 occasions by a total 200 bps and without any real impact on inflation.

It is evident that there was indeed excess liquidity to the extent of 650 bps reflecting in the CPI which disappeared following the rate hikes by RBI in 2010. However, despite RBI's various attempts to bring down inflation to ~5%, inflation has shown a strong resistance to come down from the current levels of ~10%. Inflation beyond the ~10% mark which existed during January 2011 was on account of excess liquidity and hence it responded well to the monetary measures taken by RBI. But inflation beyond the target mark and upto ~10% is not on account of excess liquidity, but due to structural changes in the demand and supply pattern which has taken place over the last decade. And therefore monetary measures may not yield desired results. At least not  until RBI raises interest rates by a further  200-300 bps. But such a move will also bring the economy on a stand still and therefore is not a desirable option. The last thing M/s Subbarao and Co. would want at this juncture is to derail the growth momentum completely.                

The last decade saw almost doubling of the per capita GDP. Growth was also buoyant at `~8%. High growth resulted in higher incomes and therefore resulted in a shift in consumption pattern. It led to a shift from intake of cereal based diets like rice, wheat to protein based diets like Fish, Milk, Meat , Eggs, Vegetables etc. Those familiar with the structure of Consumer Price Index (CPI) would know that food items have a very high weight age relative to other items in the CPI. So any increase in food prices resulting from higher demand from consumers and productivity constraints on the supply side has a direct and far reaching impact on inflation.

TRENDS IN CONSUMPTION PATTERN

This change in household’s consumption pattern, together with falling productivity in the agricultural sector points towards an impending food crisis in the country. Decades have gone past without any changes in land reforms or agricultural policies. In fact the sole reform of PDS  through introduction of UID has also run into trouble with most ministries questioning its utility. India is in dire need of a second Green Revolution and time is running out fast.  The Government is well aware of this situation, this is evident from the haste Government has shown in opening up FDI in Retail. What was till date a contentious issue, a politically challenging proposition, got introduced into the parliament and to my surprise -was cleared off !!.

Will opening up FDI in retail sector usher the much needed farm productivity in India? The Government (and its economic advisors) certainly hopes that things turn out that way. Hope, more often than not, turns out to be a quintessential delusion. FDI in retail alone “WILL NOT” solve the food and inflation problem. In fact, if implemented in isolation [i.e. without land and PDS reform, use of better cultivation techniques, phased removal of fertilizer subsidies], growth in modern retail formats backed by FDI will most likely worsen the existing problem. 

Keep Thinking.

YF - IThink