With 9.78% inflation, RBI is boxed in; over to Pranab

The latest inflation numbers will throw both the Reserve Bank and the finance ministry into a tizzy. The August wholesale prices index (WPI), released on Wednesday, has come in at a high 9.78 percent - which is significantly higher than July’s provisional figure of 9.22 percent.

Given the fact that provisional figures tend to get revised (upwards, always), August could well be the first month in which the WPI will be either in double-digits - or close to it. The June provisional figure of 9.44 percent was revised to 9.51 percent on Wednesday.

So what options do these numbers leave Reserve Bank (RBI) Governor Duvvuri Subbarao with?

The answer is none. He has to maintain the pressure by raising rates by at least 0.25 percent on 16 September, the date for the next policy review.

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There are three reasons why.

1. Past and future fuel, power and coal prices are still not fully reflected in the WPI.

2. The rupee has been falling. This means, there is a likelihood of importing inflation by our purchases of oil and other commodities.

3. Recent proposed reforms - in land acquisition laws, and in mining - will have the net effect of putting a further pressure on prices.

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In short, despite a good monsoon which will moderate food prices, the price challenge has shifted to the manufacturing part of the index, which accounts for 65 percent of the WPI’s weight, and to crude, fuel and power, which account for another 16 percent. Put another way, over 80 percent of the WPI is subject to inflationary expectations as opposed to only food last year.

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This is why Subbarao should tell the finance ministry boys to take a walk. In recent days, the ministry has been mounting pressure on Subbarao to either pause the rate hikes or even cut them. The ministry’s Chief Economic Advisor, Kaushik Basu - who has repeatedly got his inflation numbers wrong in the past - asked Subbarao to “ think out of the box".

His argument: the credit tightening was supposed to impact growth and inflation. “Unfortunately, what seems to be happening is, it is impacting growth and not having a sufficient impact on inflation,” Basu told CNBC-TV18.

Basu advised Subbarao to stop committing himself to “the policy that we have pursued in the past. It has pretty much been a standard policy, that when you have high inflation, you raise the interest rate, you mop up and bob up on credit as much as possible.” Look at Turkey, says Basu. Problem is, India isn't Turkey.

A few hours before the August WPI numbers were released, Economic Affairs Secretary R Gopalan also piled the pressure on Subbarao. He claimed that monetary policy was not quite working as it has had a limited impact on inflation. The RBI has made 11 hikes in repo rates with almost little impact on inflation.

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But Subbarao can’t afford to take these bits of advice seriously. The problem is that monetary policy can’t do all the heavy lifting when the finance ministry is having a siesta. Just as a couple cannot save much if one partner is trying to save the pennies while the other is blowing it all up at the mall, India’s problem is that the finance ministry is running a lax fiscal policy and negating the beneficial effects of monetary tightening.

Figures for the first quarter of 2011-12 show that the fiscal deficit is at a high 7.88 percent as against the full year’s budgeted figure of 4.6 percent. The fiscal deficit is an indicator of the net borrowing the government has to do to close the gap between government expenditure and revenues. The higher the fiscal deficit, the higher the pressure on inflation and interest rates.

The problem is compounded by the fact that the WPI understates inflation - and especially its near term potential. Even though Rs 1,20,000 crore of petro-fuel subsidies are still to be provided in the budget or passed on to the consumer as price increases, there’s more energy angst in store: coal prices are due to be hiked and the state electricity boards are steadily raising tariffs to cut down losses.

In recent weeks, Delhi has raised power tariffs by 22 percent, Gujarat by 4.6 percent, Rajasthan and Tamil Nadu have proposed 12-14 percent, and Punjab by 7-12 percent. Maharashtra is next . Others will follow suit as the losses of state electricity boards are mounting..

With a WPI weight of nearly 16 percent for crude, fuel and power, it is clear that the coming months will see more hikes in energy prices - with additional inflationary impacts all around. Power and coal tariff hikes will ultimately be passed on as higher prices for manufactured goods. In the August WPI, the manufacturing part of the index rose by 0.4 percent while primary articles (including food) rose by 0.9 percent and fuel and power by 0.8 percent.

Going forward, the pressure will be on the latter two components of the WPI - neither of which will come down even with a further slowdown.

Another problem is the weakening rupee, which has fallen 8 percent in less than six weeks. This means even if crude prices fall, our costs in rupee terms wont fall as much.

In the short run, there is little the government or the Reserve Bank can do to bring down inflation. Our best hope is a global slowdown, which will bring down commodity prices.

If any out-of-the-box thinking has to be done, it has to be done by Basu and his boss, Finance Minister Pranab Mukherjee. Subbarao himself has no room to manoeuvre.