There is still some doubt whether demand factors are driving up inflation in a way that will warrant RBI's immediate intervention

The news of inflation entering double digits is no doubt a matter of concern but the fact is that it was not unexpected. For May, wholesale price index based inflation was measured at 10.16 per cent.

A month earlier, in April, it was at 9.59 per cent. More significant perhaps, the government revised upwards its inflation figures for February and March to 10.06 per cent and 11.04 per cent, respectively.

There is every possibility that the figure for May will also be higher when it is updated.

That double digit inflation was anticipated is however no consolation to the government and the Reserve Bank of India. The problem with food prices persists: it makes no difference that food inflation at 16.5 per cent in May is lower than the January figure (18.4 per cent).

High prices of food, fuel and other primary articles for some months now have inflicted huge political costs on the government. The hope that food prices would moderate with a good rabi crop has so far been belied. There is a realisation that food inflation is caused not just by supply side factors but by structural deficiencies too.

Neglect of agriculture over a long period is certainly one cause. Agricultural pricing, especially the fixing of minimum support prices, in a knee jerk fashion without taking into account the wider impact of such decisions is another.

Very recently the government announced a sharp hike in the minimum support price for pulses.

The announcement came after the southwest monsoon had arrived and hence would have done very little to influence the cropping pattern. Thus the objective of increasing the supply of pulses through appropriate price signals is lost.

On the other hand, the private trade will use the government prices as benchmarks in fixing its prices with the result consumer prices will not come down.

Non-food items

Perhaps the most worrying inference from the May data is that inflation has become more generalised and is not confined to food items.

The inflation in non-food manufactured articles has risen to 6.6 per cent in May from 3.4 per cent in January.

The index of industrial production rose by 17.6 per cent in May and such a robust increase signals a new trend in industrial activity.

The capital goods sector recorded a jump of almost 73 per cent. Even granting that the low base of last year boosted the figures, there is no doubting the fact that industrial recovery is well and truly on. From a monetary perspective that would suggest an overheating of the economy.

It is this that has made many analysts think that the RBI will mark up the interest rates soon and tighten monetary policy, probably even ahead of the scheduled policy review in July. However, the case for monetary tightening is not as clear cut as would appear, based on the inflation data alone.

There is still some doubt whether demand factors are driving up inflation in a way that will warrant RBI's immediate intervention. Supply side factors obviously continue to matter quite significantly.

The monetary policy has a limited role in that context. This assessment of demand and supply factors is bound to change.

Second, the monetary aggregates so far do not suggest a surfeit of liquidity or overheating. Money supply has grown by just 14.5 per cent till May 21. Credit growth has been tardy.

External uncertainties

Three, the economy might have rebounded sharply from the crisis but there are uncertainties on the external front.

The euro debt crisis will have a direct impact on trade. It may also cause money lines and forex limits with Indian banks to be reduced. At the global level, the re-emergence of risk aversion will lead to a flight of portfolio money to safer havens. For India, that would highlight the risks in continued dependence of the external economy on these fickle funds.

Four, global economic recovery has been fragile. India with a 7.4 per cent growth last year and an expected 8.5 per cent rate this year is no doubt in the top league of Asian and other emerging economies leading the global recovery. Yet, as a recent IMF report argues, economies that are in the lead have an obligation towards other economies.

Healthy local demand

Whatever policy choices India makes will have a bearing on other countries. For instance, China, whose economic growth until recently has been dependent heavily on exports, is now driven by domestic consumption. At the global level this would suggest that a fall in demand from the developed world consequent on the withdrawal of stimulus will be offset by rising domestic demand in the bigger emerging economies.

All these are weighty arguments no doubt. But the RBI will also be guided by the fact that it has to dampen inflation expectations.

In any case, an interest rate hike has been on the cards even before inflation breached the psychologically important 10 per cent mark.


Fuel price hike imminentJune 22, 2010