As the BJP-led NDA government settles into governance, sowing seeds of controversy in the process, it is faced with the challenge of reining in food prices. Just released Wholesale Price Index data point to an unexpectedly high, month-on-month annual inflation rate of 6.2 per cent. Food prices in particular rose in May by 9.5 per cent compared with a year earlier. Actual consumer prices are rising even faster than WPI-based inflation. And with this year’s monsoon expected to be below normal, the inflationary trend is likely to aggravate.
Finance Minister Arun Jaitely has decided to make a show of being up to the task of addressing the problem, by shifting responsibility to the states. In a Facebook post, he attributed the rise in prices of food articles to “the withholding of stocks on account of apprehension of a weak monsoon," and called on the state governments to “take effective steps to ensure that speculative hoarding is discouraged."
Meanwhile, some economic pundits are trying to find straightforward causes for inflation, which they claim can be easily addressed. One such explanation, heard quite often these days, is that food prices are rising because the government has been repeatedly raising minimum support prices. If it stops doing this, food price increases, they argue, would moderate.
There are many assumptions here. The first is that it is not any imbalance between supply and demand that is influencing prices, but the rising floor set by the minimum support price policy. Second, therefore, if the government does not intervene to set a minimum price at which it would procure stocks of commodities like rice and wheat, food prices would not rise and could possibly fall. Third, even if prices fall, production would not be affected to a degree where supply-demand imbalances drive up prices.
Clearly, Finance Minister Arun Jaitely, who sees expectations of a deficient monsoon and speculative hoarding as underlying the price increase, does not go along with this view. But that is not the reason why the MSP hike explanation for food price inflation needs to be dismissed. It is also because the evidence does not support the explanation, and because the explanation confuses symptom for cause.
Consider paddy and wheat, for example. An examination (Chart 1) of increases in the MSP for these commodities over the last five years shows that year-on-year changes: (i) have been quite volatile, indicating that there is no simple proportionate rule that influences where the MSP is set; and (ii) there have been three years when the increases in MSP have been below the overall inflation rate, and in the case of wheat at or below 5 per cent, suggesting that MSP increases have not been abnormally high.
This should not surprise, since the MSP recommended by the Commission for Agricultural Costs and Prices (CACP) is supposed to reflect costs of production plus a reasonable return. The adoption of this measure of price intervention was part of the strategy to raise food production through the Green Revolution. An essential component of the Green Revolution strategy was the decision to incentivise production by setting a ‘remunerative’ cost-plus floor to certain agricultural prices. The government guarantees purchases at these prices of surpluses delivered to it during the procurement season. The farmers, on the other hand, can either sell their produce to government agencies at the MSP, or in the open market, depending on which is more advantageous to them. This does mean that (a) the MSP sets a floor to the open market price; (b) that floor is determined by cost of production movements; and (c) that the flow of grain to the government’s warehouses would vary with changes in the levels of production and supply, which influences the level of open market prices relative to the MSP floor. Thus, demand-supply imbalances do have an effect on market prices and government foodstocks.
To summarise: how much the recommended MSP rises would depend on how much costs of production increase. What is more, as Chart 2 indicates, in most recent years the actual support price provided by the government has equalled the recommended MSP. So if a rise in the floor set by the MSP is seen as responsible for inflation, this must be due to increases in costs. This increase in costs has, in turn, been partly determined by cost increases resulting from reform-induced increases in administered prices and cuts in input subsidies. The effort to reduce subsidies has resulted in a continuous increase in the prices of commodities such as petroleum and fertiliser whose prices are administered. A rise in the MSP was the inevitable outcome.
But this was and is not the only influence on market prices. The government has opted for raising the issue prices of food provided through the public distribution system in order to reduce the subsidy bill as part of fiscal reform, and pushed up market prices in the process. Moreover, imbalances between demand and supply of primary products have been accentuated by the government’s reluctance to release additional food through the public distribution system in order to curb subsidies. These factors too have imparted upward pressure on market prices. Thus, cost-push and demand-pull pressures, resulting partly from economic reform, are in substantial measure responsible for the buoyancy in food prices. This means those who blame food price inflation on the MSP do not just confuse symptom with cause, but also ignore the effects of reform that need to be addressed in order to combat inflation.