Don't believe them; prices ain't coming down too soon
Inflation in India has become structural. We are in a high inflation trap and it will be hard to come out of it.
By Madan Sabnavis
Predicting inflation today appears to be a lost cause as it is based more on hope riding despair rather than sound economic reasoning.
We have been told that the number (based on the wholesale prices index) will come down to 7 percent or 6 percent by March-end and that it will be elevated around the 9 percent mark till October. But, the fact is no one really knows how this will happen.
One may recollect that we had similar forecasts last year, which did not quite materialise. October seems a logical benchmark because of the kharif harvest, which will augment supplies, and hopefully, lower prices. March is the other target month, when, presumably a good rabi harvest, will bring down prices further. But what we are missing out is that the same production trends last year did not quite lower prices.
If we look at the inflation index, which has been remodeled using 2004-05 as the base year, broadly farm products account for 20 percent of inflation, fuel products 15 percent and manufactured goods the balance 65 percent. Today our inflation is originating from all the three sectors - which is a cause for concern.
But the problem is we will find it hard to bring down inflation because each sector presents its own conundrum. In fact, we are in a high inflation trap and it will be hard to come out of it. High prices are here to stay, notwithstanding the statistical base phenomenon that helps lower rates notionally in some months.
Let us see agriculture first. Last year we took pride in farm output reaching its zenith with rice, wheat, pulses and oilseeds reaching new output heights. Yet, food inflation remained at over 10 percent for most of the year. The high base year effect of 2009-10 on account of the drought did not provide a helping 'statistical' relief.
The reasons for this problem are actually two-fold. The first is that the government, through the Commission for Agricultural Costs and Prices (CACP), has been relentlessly increasing the prices of farm products by between 30-40 percent in the last four years. While actual procurement takes place only in rice and wheat, the benchmark prices of other products such as pulses and oilseeds move up in the market. Therefore, there is an upward pressure on prices here.
The CACP uses a complex formula based on cost of cultivation, inflation, price of alternative crops, wage costs, price of diesel and so on to fix the MSP (minimum support prices). Intuitively, past inflation gets imbibed into current prices, which add to the spiral.
The second problem is that farmers have still not managed to improve productivity. With most crops yielding more or less a fixed output, as land under cultivation remains more or less static, farm incomes move up only marginally every year. To keep pace with general inflation, as every producer has to pay more for other food products, there is a need to increase farm-gate prices. The final prices hence are being driven by market forces of a different kind.
Further, the government also abets this price increase though large scale procurement of wheat and rice, where just around 70 percent of production enters the market. The FCI (Food Corporation of India) becomes the biggest hoarder of foodgrain as the procurement scheme ends up taking in around 30 percent of the wheat and rice produced, leaving just 40 percent for the market. This counters the excuse of high prices being pushed to the demand front, where the National Rural Employment Guarantee Act (NREGA) is being blamed for the same!
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On the other hand, fuel products inflation is clearly in the hands of government. The base price is set by the global markets. This is just the starting point. The oil marketing companies (OMCs) are making huge losses by selling products in a situation of partial deregulation. The government has to decide whether it should be increasing prices or not. This impacts the consumer as well as the OMCs, with the fiscal subsidy being at the back of its mind.
The conundrum here is that there are three pressures that have to be balanced even when global oil prices come down or stabilise - as is the case today. Should lower prices be passed on to a largely subsidised market? Or should it be used to cut down the losses of the OMCs? Or should the subsidy bill be lowered further?
While there are arguments for every line of action, the final result actually vests with the government itself. Therefore, this section of inflation is largely policy-driven.
The last piece of inflation is on the side of manufactured goods. Here around 12 percent is food-based, over which there is little control because demand is more or less inelastic here. If the price of wheat goes up, so will the price of biscuits and bread. Another section of 8-10 percent is imported - like metals and metal products, fertilisers, and other chemicals - about which again the government can do little.
This leaves a section of 15-20 percent where the Reserve Bank can lower demand to cut inflation. This is done through interest rate hikes which, in turn, help to quell demand both on the consumer and investor side. If we can cut the demand for housing, it will impact demand for steel, cement, machinery, etc. High rates can affect investment for machinery which, in turn, will lower prices. This is what the RBI is actually hoping for when it keeps increasing interest rates.
To sum up, a large part of the inflation has become congenital to the system. When the price of sugar rose from Rs 20 to Rs 40 a kg or that of pulses (tur) from Rs 45 to Rs 100 in 2009-10, it was expected that they would come down after the next crop. A bumper crop in both sugar (we are again talking of exporting excess sugar) and pulses has brought prices down to Rs 30 and Rs 65-70 respectively. But we will never go back to the earlier levels.
Clearly, new inflation standards have been set. The fact that there is talk of revising the new base year for prices to 2010-11 or 2011-12 tells its own story. This seems to be the only way of actually bringing down - statistically at least - the WPI inflation number. We are in a high price regime and, quite unfortunately, this seems to be the only way out.
The author is Chief Economist, Care Ratings. These views are personal.
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