So, will the widening CAD and fiscal deficits undermine RBIs efforts to control inflation From a laymans perspective, inflation means a rise in the price of essential commodities. In the parlance of economics, the price of any item rises when there is more demand relative to supply. Managing inflation, therefore, amounts to managing the demand for the product experiencing a rise in prices, or by increasing the supply of this item. In the case of managing a recession, exactly the opposite chain of events should take place. Before we go into how effective RBI has been in managing inflation, it is important to know what constitutes these demand and supply-side factors.
Among demand-side factors, consumption expenditure is important. In India, consumption expenditure contributes close to 65% of our GDP. The other components are private investment expenditure, government expenditure and trade. RBI can only be successful in controlling inflation if the rise in interest rate (read, repo and reverse-repo rates) reduces consumption, private investment and government expenditure.
Three important assumptions are necessary for RBI intervention to be successful. First, there has to be a perfect pass-through in terms of the change in repo rate and reverse-repo rate leading to a corresponding change in lending rates of commercial banks. However, in reality, the pass-through is not perfect, and happens with a lag. Second, if prices rise more than proportionately in spite of RBI increasing nominal interest rates, it implies a fall in the real rate of interest.
This is likely to happen with government partially deregulating diesel prices, considered an intermediate input. Therefore, an increase in nominal interest rates may not check the increase in aggregate demand, as the real interest rate has fallen. In 2013, there are expectations that the government is going to increase the price of diesel by 10%. Therefore, an important assumption for a nominal interest rate increase to be effective is price stickiness, which does not hold true, except perhaps for fuel and power items in the short-run.
The third and most important assumption is a reduction in consumption, which also depends on the types of goods we are consuming. If the goods consumed are income-inelastic, or where consumers do not care about price of goods consumed, then a rise in interest rates will not reduce demand.
It is to be noted that the price of primary commodities and fuel itemssomething we must necessarily consumehas risen by around 13% during the last three years. This figure would have been much higher with a total de-control of diesel, gas, petroleum, and kerosene prices.
Recent Wholesale Price Index data reveals that food items have a total weight of 24.3%14.3% for primary items such as cereals (4%); eggs, meat and fish (2.4%); and milk (3.3%); and 10% for manufactured food items such as potato chips. The other major items of consumption are fuel and power (15%) and chemical and chemical products (12%). Thanks to Indias growth story, consumption of these superior items has increased. The price rise in essentials shows up in a high level of general prices because of the high weights of these items in the price index.
Is it only demand-side factors that are fuelling inflation Inflation can also occur due to short-supply of essential consumption items. For instance, there has been a major reduction in food crop acreage. Measured in terms of lakh hectares, acreage for rice, coarse cereals, pulses, and oil seeds, have fallen by 10.79, 11.63, 2.09, and 2.23 lakh hectares, respectively, in 2011-12 over 2010-11.
Farmers complain they do not get adequate labour to undertake farming activities, thanks to schemes such as Pradhan Mantri Gram Sadak Yojana (PMGSY) and Mahatma Gandhi National Rural Employment Guarantee Scheme Act (MGNREGA). To hire workers, farmers have to shell out anything between R180 and R300 per day, the rate varying from state to state.
The shortage is likely to continue with the implementation of the Food Security Bill. This Bill, when passed, will entitle 67% of the Indian population to food at a highly subsidised rate, with 7 kg per person per month to below poverty line households, and 3 kg per person per month to the general category households.
With the government continuing with its reform agenda, in terms of bringing down fertiliser subsidies, it will further dampen the realised price for the farmers, and hence the incentive for farming. As a result of this legislation, the cost to the exchequer will rise to R1.18 lakh crore, further widening the fiscal deficit.
Over last one decade, the annual growth of our agriculture output has been less than 3%. This year, below-normal rain could bring that growth rate down, with around 55% of our agricultural produce dependent on rainfall.
Lower agriculture produce also means higher fodder prices for livestock, leading to an increase in the price of meat, eggs, and milk. Capacity constraints in the form of lack of storage facilities and an imperfect market due to a lack of reforms in the APMC Act have also contributed to a price rise in India. With so many factors at work, if RBI goes for a rate cut, which many believe will happen, it is suggested that the government lend adequate support in terms of reducing non-essential imports such as gold, and taking measures to control fiscal deficits. The good news is with direct cash transfer slowly being put in place, it is expected that the government will be able to better utilise its funds, and control the fiscal deficit.
The author is professor, Institute for Financial Management and Research, Chennai