A clear transmission channel should be established to ensure effective pass-through of RBI policies.

Unprecedented inflation and inflationary pressure fuelled by supply side constraints in India, especially by the sustained rise in food prices, could derail overall inflationary expectations by policy makers, which will have a long-term impact on policy making. The sharp fall in monsoon rains, 23 per cent lower than the average and the weakest since 1972, has affected agriculture production leading to price escalation of food items.

Inflation rate leaped to a 13-month high of 7.31 per cent in December from 4.78 per cent in the previous month on higher food prices. In December, inflation of food articles reached 19.17 per cent on the back of higher prices of pulses, which was 42 per cent higher than a year ago, vegetables 39 per cent and potatoes 124 per cent. Prices of manufactured food items have also gone up sharply by 26 per cent mainly due to higher sugar prices, which was 52 per cent.

Upward bias

Already, inflation expectation has crossed the Reserve Bank of India’s forecast of 6.5 per cent by the end of this fiscal. There is a hue and cry from all quarters attacking the Government on this alarming situation. The fear of these rates touching the double-digit level is more alarming. In its second quarter review of monetary policy in October 2009, the RBI had projected that Wholesale Price Index (WPI) inflation would touch 6.5 per cent by March 31, 2010, “with an upward bias” up from the 5 per cent forecast in its first quarter review in July 2009. This month end, in the third quarter review, the RBI is likely to revise these rates, surely, with an upward bias again.

However, the wide gap between various methodologies to assess the inflation would add more woes to policy makers. “There continues to exist two technical problems with the monetary policy — persistently high inflation, and ambiguous price gauges,” said a new study ‘Impact and policy responses — India’ commissioned by Asian Development Bank (ADB) recently.

In the high growth period in the last five years, the RBI had been unable to keep prices adequately under control. The last time consumer price inflation was below 5 per cent was in January 2006, a span of 42 months with inflation over 5 per cent. The wholesale price index has generally been lower, except in 2008 when the WPI inflation averaged 9.1 per cent. This has often raised the concern that the RBI might be biased in its trade-off of risks towards prioritising the growth objective rather than the inflation objective. Without a clear anchor for monetary policy, there is lack of consistency in the long term. The RBI has two primary measures of inflation — the wholesale price index (WPI) and the consumer price index (CPI). Even among the various CPIs, there are four sub-categories for the various groups of workers. It is understandable for a diverse country like India to have more than one measure of inflation, but the inconsistencies in the two measures do seem peculiar. The correlation between the two indices is 0.22.

As of October 2009, the CPI-based yearly inflation read 11.5 per cent while the WPI-based inflation read 4.8 per cent. The CPI rate has been rising since March 2009 while the WPI rate had been decreasing until July 2009. The pith of the issue is the difference in the index make-up. While food is a majority category for the CPI, it has only a 15 per cent weight in the WPI.

“India’s inflation is hard to manage as the factors are often exogenous and not simply a consequence of a domestic demand-supply function. Prices are affected by import prices, trade channels, capital flows, monsoon, and commodity prices. Thus keeping inflation under control requires efficient monitoring of data and the ability to react swiftly,” the study states.

Suggestions

ADB has two main suggestions for monetary policy changes: Make the CPI the main policy measure: Instead of two primary indicators of inflation, the RBI should shift to a single and more comprehensive index which measures the actual price consumers pay. An updated version of the CPI should be used as the measure of inflation.

More balance towards inflation control: Beside the difficulties in measurement, the RBI should not compromise inflation in favour of higher output. While a multi-objective policy in India is probably better than inflation targeting, the policy should put more emphasis on inflation control. A clear transmission channel should also be established to ensure effective pass-through of RBI policies.

OOMMEN A. NINAN