Catch-22 for Modi govt: Why inflation may get worse before it gets better

The consumer price index number is due tomorrow (12 June), but I am not expecting any great moderation despite the economic slowdown. In April, the index hit a three-month high of 8.59 percent, and a Reuters survey of economists predicts a small dip to 8.4 percent in May.

A Reserve Bank survey of inflationary expectations among households says that prices are likely to stabilise around current levels. A report in Mint notes that in September 2013, 74.5 percent of the households surveyed expected prices to rise, which the survey conducted in March showed only 51.2 percent thought prices had still some way to climb.

We should not fool ourselves. My prediction is that if the Narendra Modi government opts for big-bang structural reforms, inflation will worsen in the short term and growth will be weak, but we can expect a sharp rebound from 2015-16 onwards. But if the government opts for incrementalism and compromise, inflation will remain stuck in a high groove and growth will remain anaemic for a much longer period of time. NDA-2 will become a replay of UPA-2.

The problem is inflation in India is structural in nature. I have been saying this for a while, and unless we address the fundamental issues that make inflation endemic, we are not going to see any major moderation in the short or even medium term.

Inflation became a structural issue during the UPA regime because it made the rigidities in various markets worse by endless resort to subsidies and administered price-fixing. It was only towards the end of the UPA regime that the government started realising its folly and moved towards market pricing in one key subsidised fuel - diesel. But even as one problem began to subside, it made the problems worse in other markets - land, food, fertiliser, labour.

Inflation becomes difficult to mitigate when you interfere with normal market functioning and refuse to allow demand and supply to adjust naturally. This is what the NDA must correct, but the upshot will be a possible spike in inflation in the short term as the market adjusts to a reduction of subsidies in vast areas of petro-goods, fertiliser and food.

Consider the roots of the current inflation. It had its origins in a few factors, of which only one is external to us. The external factor is high oil prices - which we cannot control except by allowing prices and demand to adjust. This is why the problem continues to fester.

The UPA’s direct contribution to endemic domestic inflation was the result of the following factors.

First, in 2008-09, it set off huge food inflation by dramatic increases in minimum support prices (MSPs) in the range of 30-75 percent (read here ). Obviously, this disastrous decision was influenced purely by the need to win the 2009 elections. Food inflation has never looked back since then.

Second, the UPA injected massive money into the rural areas - both through the NREGA make-work scheme and large investments in rural roads, etc. The injection of money improved rural income levels, pushing up farm wages, and the additional incomes went to create demand for non-cereal food. This is how food inflation spread beyond cereals to protein items, including pulses, eggs, milk, and fruits and vegetables. When incomes improve, the poor eat better food.

Third, the combination of high MSPs, high rural wages, and high food prices ensured that we had a wage-price spiral, especially since NREGA wages are indexed to inflation. The only way to douse inflation is through a supply side miracle, but NREGA created few assets to improve agricultural productivity. Moreover, to increase the production of protein items, you need to increase the area under pulses, increase the milch cow herd , and improve poultry productivity. This has manifestly not happened: if you bring more land under pulses, other crops will get less land. As for milk, Subir Gokarn, former Reserve Bank Deputy Governor, noted in a lecture delivered in December 2011, that “the only way in which milk production can be increased is by increasing the size of the cattle herd.” The NDA needs to act on this issue urgently.

The supply side is not so easy to tweak in the short term, except by imports. Raising pulses productivity and milk production, not to speak of eggs, meat, fruit and veggies, is a long-term process. The NDA has to tackle this issue - but don’t expect early results.

Fourth, the UPA’s biggest folly was to refuse to raise fuel prices in smaller doses earlier when it became clear that global prices were on fire. The process began only in 2012, but it is far from complete. It embraces only diesel, and, in the months before the general election, Rahul Gandhi made the problem worse by increasing the subsidised supply of LPG to households from nine cylinders to 12. This means, over 90 percent of consumers will now be subsidised. But the subsidy challenge is not only related to kerosene and cooking gas, but fertiliser, diesel and even food.

Fifth, as if the existing market rigidities were not enough, the UPA, in its desperation to prevent a rout in the 2014 general election, made things worse by legislating the Food Security and Land Acquisition Bills. The Food Bill targets two-thirds of Indian households for the supply of rice, wheat and coarse cereals at the super-subsidised rate of Rs 3, Rs 2 and Re 1 a kg. This will disrupt the food market and increase corruption as subsidised cereal leaks out of the public distribution system. In land, in the name of ensuring fair prices for acquired land, the UPA has essentially made it impossible to acquire land at reasonable prices and in reasonable time for worthwhile projects. The land market is further distorted, and growth will be tough to revive without easier land availability.

It is not clear how fast, and even whether, the NDA government under Modi will move to correct the distortions in various markets. Even if it starts reducing subsidies and freeing the markets for labour, land, fuel (including gas) food and fertiliser, the short-term consequences are a spike in inflation.

If the NDA does not do this, the impact will still be inflation as the fiscal deficit worsens and the country heads for a rating downgrade.

So what lies ahead?

Narendra Modi needs to do the right thing rather than opt for messy compromises. India is ready for its second big-bang reforms, something similar to 1991.

The immediate impact of the 1991 reform was a sharp fall in growth (in 1991-92, GDP growth fell to 1.4 percent) and a spike in consumer inflation (13.5 percent).

It won’t be that bad this time, for the Indian economy has evolved. But Modi should bite the bullet and take the short-term setbacks on the chin and ensure that the economy rebounds faster in the years ahead.

The decisions may be difficult for his party to explain to voters in the forthcoming assembly elections, but the voter will surely be willing to give Modi some credit for speaking the truth and acting in our long-term interests. It can be done, especially if Modi chooses to communicate the changes effectively and prepares the country for what lies ahead.

The 1991 changes gave reforms a bad name because politicians failed to explain what they were doing and why. This is what Narendra Modi must correct if he intends to change the course of politics and economics during his tenure. It is more important to talk to the people after the elections than just before it.