Inflation: The changing nature of the beast

At present, the prevailing view at RBI is that any tightening of monetary policy to control inflation runs the risk of derailing the ongoing economic recovery

Though CPI (or retail) inflation in India is still within the RBI target band of 2-6 per cent, WPI (or wholesale) inflation has crossed the 14 per cent mark, a 12-year high. The recent surge in WPI is being regarded as an advance signal of a hike in CPI inflation in the near future.

Why do WPI and CPI often follow different trajectories? This is because the weights given to different commodity groups in these two indexes are different. For example, nearly 50 per cent weight is accorded to food items in CPI while it is less than 20 per cent in WPI. In addition, services figure more in CPI since most services (like education, healthcare, transportation) are not bought and sold in the wholesale markets. Further, prices of machines and raw materials enter WPI but not CPI.

Though our official measure of inflation (or ‘headline inflation’) used to be WPI, India switched to CPI in 2014. Also, the RBI, while targeting inflation, looks at CPI. But then, the range of CPI inflation (4 per cent plus/minus 2 per cent) is not the only target that RBI is concerned with. It also considers the so-called ‘output gap’ or the gap between actual GDP and potential GDP.

At present, the prevailing view at RBI, despite WPI shooting up alarmingly, is that any tightening of monetary policy to control inflation runs the risk of derailing the ongoing economic recovery. But then, the way WPI is behaving, the day is not far off when RBI will have to tighten its monetary policy stance, even at the risk of hurting growth.

The current surge in inflation is due to a number of factors, on both the demand and supply sides. The growth rebound following the sharp fall in GDP and employment (due to the onset of Covid pandemic) should not have caused such a big rise in inflation numbers, if there were no supply bottlenecks. Of course, some rise in prices of oil and metals is inevitable when demand rebounds just as these prices fall when economies go into a recession. In fact, the price of fuel and power has risen nearly 40 per cent between November 2020 and November 2021.

However, for general inflation to go up to this extent, a rise in the prices of manufactured goods has to occur. ‘Core inflation’ (which excludes food and fuel) has also reached a 5-month high of around 6 per cent in November 2021.

Here, analysts are blaming shortages of crucial inputs like microchips due to Covid-related breakdowns in global supply chains and rising transport costs and logistical problems like shortages of shipping containers and congestion in ports. With the extremely swift spread of the Omicron variant, the chances of more closures, more disruption of supply chain logistics and labour shortages are high.

In developed countries, wages have also started to rise to keep pace with rising prices, leading to some kind of a wage-price spiral. Though this catching up of wages with prices does not happen to the same extent in India, it affects Indian prices to the extent the cost of imported consumer goods goes up and the rise in prices of imported inputs pushes up costs of manufacturing in India. With demand rebound, along with a shortage of supplies, the power of manufacturers to pass on rising costs to consumers is increasing. Weather factors (like unseasonal heavy rains destroying standing crops) have also played a major role in raising prices of food articles like vegetables and fruits, even in winter when such prices reach their lowest points.

The current bout of inflation is a global phenomenon. US inflation has reached the highest level in four decades while inflation in the UK is at its highest in over a decade. The stock markets have started factoring in the impact of the Fed ‘tapering’ off its bond purchases (which, by injecting money, keeps interest rates low). The expectation of an impending rise in interest rates in the US and EU is already causing a fall in stock prices in the emerging world, including India. It is simple arithmetic that stock prices are inversely related to interest rates. In addition, the tightening of monetary policy in the US, as and when it happens, will induce more outflow of foreign funds from the Indian stock market, leading to a further depreciation of the Indian rupee which, in turn, would raise the rupee cost of imports and the inflation rate.

The likely rise in interest rates by RBI to combat inflation would be good news for people living on bank fixed deposit interest and bad news for borrowers. In this connection, it is interesti ng to note the changing nature of inflation in India over the years.

In post-Independence India, inflation used to be mainly food inflation, triggered by weather factors like drought or unseasonal rainfall. Subsequently, the success of the Green Revolution brought grain prices down, the importance of agriculture in GDP and CPI also declined. High fiscal deficits and loose monetary policy became increasingly important causes of inflation in the 1980s. Even within the food group, the importance of grains declined as people moving up the income ladder switched to a more diversified food basket, consisting of more vegetables, pulses, milk, eggs, fish and meat. Due to supply constraints, the relative prices of such food items have been going up while there is chronic excess supply in grains, thanks to rising government procurement prices incentivising farmers to grow grains.

In more recent times, inflation has often been triggered by a rise in the international dollar price of petro-products, depreciation of the rupee, which raises the rupee price of imports, and rise in government (central and state) taxes. Also, crop failures due to seasonal factors and a chronic shortage of pulses and edible oil have been contributing to food and CPI inflation. The role of fiscal deficit financed by printing of notes (‘deficit financing’) has been declining due to the steady decline in monetised fiscal deficit as a percentage of GDP, except for tackling exceptional situations like the Covid-induced sharp recession by big doses of fiscal and monetary stimulus.

In the pre-liberalisation era, inflation in India used to cross the 10 per cent mark in many years. However, in the post-1991 period, the new normal for inflation became an average of 5-6 per cent. It seems, in the near future, the inflation trajectory would be well above this normal, with all its attendant consequences. In the prevailing global uncertainty, nobody knows, for how long.

(The writer is a former Professor of Economics, IIM, Calcutta, and Cornell University, USA.)

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