Column: Puzzle of high CPI inflation

Written by Surjit S Bhalla | Updated: Nov 24 2013, 00:07am hrs
There is something strange going on with the Indian macro-economy, especially with inflation. Zyfins latest inflation estimates for the GDP deflator for the period October 2012-September 2013 is at a 6.7% rate. GDP growth for the same period is expected to be at a low 4.7%. CPI inflation, the new preferred measure of inflation at RBI, was above 10% in October. There are frightening stories about vegetable inflation, onion inflation, etc, being upwards of 50%. Depressing growth and escalating inflationwhat is going on

The most common explanation (more in the nature of an excuse) for high inflation in India is to take recourse in the high international inflation in 2008, and the subsequent expansion of deficits around the world. But that was a one-year explanation for inflation in the developing worldexcept India! As the accompanying table shows, Indian CPI inflation has ranged between 8.4% and 12.4% in the last six years. It is not as if this high inflation has gone unnoticed by the experts or RBI. Each year there has been a new explanation for this persistence of inflation. Some of the popular candidates: high fiscal deficits, excess demand (then why is growth so low), pricing power of Indian corporate (then why is non-food inflation contained) the emerging middle class eating protein-rich food (then why did cereal prices go up so much), and rupee depreciation (shouldnt the cause be the other way).

Then, there have been explanations as to why inflation should be going down. In case you have forgotten, there is the claim that food output will grow strongly and be at record-highs this year. In the last three months, the rupee has appreciated by more than 10%, but CPI inflation has not declinedindeed has gone higher. And of course there has been the 400-odd basis points' increase in repo rates by RBI; yet each year, and after each increase, CPI inflation has edged higher, and from a high base!

It is true that some food price increases (e.g., onions ) have defied weather, or economic logic, but the entire food chain doing so is stretching both logic and imagination. How does one reconcile record food output with the literally spiraling inflation of food The Congress party does this stating that its policies have engineered growth in the rural areas, and inclusive growth at that.

If incomes in the rural sector are booming, then incomes in the richer sectors must be collapsing to yield a GDP growth rate of only 4.7%. And this number is put in perspective by noting that the last three years of per capita GDP growth in India is lower by a magnitude in the last 20 years and at 3.3% per year, it is less than half the per capita growth that prevailed during the boom years leading up to the 2009 election.

So, what is happening The logic of Indian inflation is relatively simple and has been outlined in these columns many times before and was documented in detail in July 2011 in Indian InflationPopulism, Politics, and Procurement prices, available at The table updates these data till 2013.

What happens when the government raises the minimum support price (MSP) of foodgrains, especially that of rice and wheat, two crops that account for almost half of the value of all the crops for which the government sets the MSP. When the government raises the MSP, the prices of factors of production involved in the production of MSP productsland and labouralso go up. Is it any surprise that rural wages have gone up so fast as to cause labour shortages in an economy with relatively jobless growth for the last nine years For the last six years, rural wages have gone up by an average of 16%. We dont have reliable data on rural land values but anecdotal data suggest that the price of this factor of production has also been rising faster than most prices in the economy.

So, does this not increase the chances of Congress getting elected in the rural areas This is mostly why the Congress-led UPA did itincrease rural incomes where the votes are. However, given the state election results of the last few years, this strategy seems to have backfired. One important reasona dominantly large share of the expenditure of the poor is on food, and food prices have risen much faster than the average CPI increase of 10%, resulting in a real wage increase of less than 3% per yearat best.

The UPA answer to the high procurement prices in the run-up to the 2009 election was that these prices were being increased because international prices of food were going up. As indeed they wereworld food prices (FAO data) increased at an average compounded rate of 6.7% per annum between 2004 and 2009; UPA procurement prices increased at an average rate of 9.9%. Since 2009, in the last four years, international prices of food have risen 7.3%; UPA-II price increase per year9.3%.

The link between procurement prices and CPI is very strong both theoretically and empirically. The accompanying table reports the results of a model which relates CPI-increase to only one variable, the one-year lagged growth in procurement prices. The model is very parsimonious; no fuel prices here, no rupee value, no fiscal deficit, no money supply, no repo rate, no RBI, no purchase of gold, and no current account deficit. Yet, this model explains Indian inflation very well. For each 10% rise in previous years procurement prices, there is a predicted 3.3% increase in the current year CPI. In other words, if there was a zero-rise in procurement prices last year, on an average this years CPI inflation would be 4.6%. The estimation is for the period 1978-2007, so all of UPA-II data are out of the sample.

Particularly galling and adventurous and destructive was the UPA administered procurement price increase of 11.5% in 2011 and 16.2% increase in 2012. In 2012, the price of rice was increased by 16%, coarse cereals by 20%, sugar by 17% and wheat by 5%. The model predicted a 10% increase in CPI in 2013; the actual result10%! The average forecasting error for the out of sample six yearsonly 1% per year.

Six-year CPI inflation, in 2008-13, has been the highest since 195010 percent per annum, matching the 10.1% rate achieved in the six years ending 1975. For the six years ending 2012, the MSP increase has also been the highestaverage of 12.5% per annum. A lag of one year as per the model. The UPA will say coincidence, I will say rank stupid populist policy which did not help rural India (except land-owning farmers), lost them (the Congress party) the state elections, and lowered the GDP growth far below its potential, and below anyones imagination.

The author is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla