In the middle of a muddle

While economists of repute increasingly populate India’s policy-making establishment, holding regular or advisory positions, economic policy itself seems ever more self-contradictory. Consider, for example, the monetary and fiscal policy recommendations being made by this establishment as reported by the media. There is a growing consensus within it that the Reserve Bank of India should reduce overly high interest rates to revive growth, even while maintaining a close watch on inflation. In this view, inflation is a threat, but not so much as to warrant stifling growth with high interest rates. Responding to this pressure the RBI has in its recent annual policy statement decided to go in for a significant half-a-percentage-point reduction in the repo rate.

Meanwhile another argument is gaining ground that fiscal policy should play a greater role in controlling inflation. The magic remedy for inflation being recommended by adherents to this view is a reduction in the fiscal deficit on the government’s budget. Besides being based on the belief that a reduced fiscal deficit would automatically rein in inflation, this recommendation is noteworthy for the specific way in which the reduction is sought to be ensured. The government is being urged to reduce its expenditure to curtail the deficit by raising administered prices and user charges and cutting budgetary subsidies. More specifically, a case is being made out for raising the prices of petroleum products so as to reduce subsidies or transfers to the oil marketing companies. In recent times this establishment demand has become an orchestrated campaign. The argument from sources in the Finance Ministry and the Planning Commission seems to be that if you raise a set of prices that would reduce the fiscal deficit, the overall rate of price increase would be lower and not higher.

This push for raising administered prices to reduce the fiscal deficit is supported by other similarly “potent” arguments. For example, former IMF chief economist and advisor to the Prime Minister, Raghuram Rajan, has at a function held to release the second edition of a festschrift in honour of Manmohan Singh, reportedly called for a complete freeing of diesel prices in order to rein in the fiscal deficit and boost the confidence of foreign investors.

All this is confusing indeed. It is known that since petroleum products are in the nature of universal intermediates, increases in their prices inevitably have a cascading effect on costs and prices of other commodities and result in an acceleration of inflation. And since cost-push inflation is unlikely to be smothered by reduced demand, it would be realised despite any reduction in the fiscal deficit that may ensue. So, while the RBI is being advised to cautiously stimulate demand and growth, while keeping a watch on inflation, the Finance Ministry is being cajoled into stoking inflation by hiking a range of prices.

This policy muddle is all the more disconcerting since it seems to be accompanied by a misreading of the inflation scenario. The case for reducing interest rates is backed by evidence that annual inflation as measured by month-on-month Wholesale Price Index (WPI) trends is much below its recent peak and still declining. However, other evidence suggests that inflation in India still rules high. According to the recently released Consumer Price Index (CPI) numbers for March 2012, the annual month-on-month rate of inflation had risen to 9.5 per cent from 8.8 per cent in February and 7.7 per cent in January (see Chart). Since this new series of All India Consumer Price Indices (with 2010 as base) are being released only from January 2011, these are the only months for which inflation figures can be calculated as of now.

Those figures point in two directions. First, that inflation at the retail level is high and rising, especially because of inflation in the prices of food articles such as milk and milk products, vegetables, edible oils and eggs, meat and fish, besides fuels. Second, that there is a growing divergence in inflation trends based on the WPI, on the one hand, and the CPI, on the other, with inflation based on the WPI ruling lower and falling from 7 per cent in February to 6.9 per cent in March.

To recall, the official justification for the release of the new CPI series was the argument that the WPI was not reflecting retail price trends adequately and that inflation measurement based on retail consumer prices was the international practice. The release therefore marked the beginning of a transition in which the government and central bank were to rely on this new index rather than the WPI to compute the “benchmark” inflation rate in the economy.

Preponderant among the goods that enter the nation’s consumption basket and therefore the CPI would be food articles and fuels. The supply of the former articles is more volatile (because of variable monsoons, for example) as well as less responsive in the short run to changes in demand. Their prices, therefore, tend to be more buoyant than that of most other commodities. On the other hand, because of political and economic developments in countries contributing a major part of the world’s energy supplies, the fuels component of the consumption basket is also more “inflation” prone than many other goods. In the event, there is a significant threat of an acceleration of inflation as measured by the CPI.

Since according to that yardstick inflation is still with us and would possibly climb, it could be argued that the RBI, which is convinced that a hike in interest rates is the appropriate weapon against inflation, was pushed into cutting interest rates at this point. However, the muddle over policy seems to afflict the RBI as well. In its recent assessment of Macroeconomic and Monetary Developments over the last financial year, the central bank has also come out in favour of increases in petroleum product prices and other input prices to address the threat posed by “suppressed inflation”. That is, since the transmission of international prices is inevitable, imported inflation can only be suppressed and not avoided. And, if supressed, inflation is a threat. However, if that be the case, since further inflation is almost a certainty, the RBI’s by its own logic would be forced to reverse its interest rate reduction decision. Why cut interest rates then?

Perhaps recognising this contradiction the RBI states: “The upside risks to inflation on the one hand and the depressed domestic growth outlook on the other, warrant calibrated measures to maintain a sustainable balance in a dynamic growth-inflation scenario.” Presumably, that is about as clear as one can get.