Inflation: sources and policy options

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Friday , May 09, 2008 at 2220 hrs Wholesale Price Index (WPI) inflation has been rising almost continuously on a point-to-point basis since October 2007. It stood at 7.57 % in the week ending April 19, 2008. This is a provisional figure. If past trends are any indication, the final figure could be closer to 8%. CPI (rural), which has greater weightage for food, is running roughly 1.5% above WPI.

The rise in the rate of inflation is a combination of the base effect, global inflation in commodities and oil, and excess money supply. The WPI inched up very slowly from 208.8 to 211.9 between end-October 2006 and mid-June 2007. This has had the effect of magnifying the inflation rate during the corresponding period of the subsequent year, since the rate measures the increase in the index relative to the same time in the previous year. Consequently, after bottoming out at 3.07% in mid October 2007, inflation has continued to climb, crossing 7% in April 2008. Even if the WPI index were not to rise at all from its present level, inflation is likely to remain above 7% till end-June, and above 6.5% till August 2008, simply on account of the base effect.

Global inflation rates are also rising, especially in food, fuel and commodities. In the ultimate analysis, the spurt in food prices is attributable to the sharp increase in oil prices, leading to increasing diversion of foodgrain and edible oil to produce ethanol and biodiesel, and pushing up production costs. The Economist commodity index increased by 29% over the past year (as of April 29, 2008). Food commodities rose by 61 % and oil by 80%. The falling dollar has also contributed to rising global inflation, since international trade is mostly priced in US dollars. India is now much more integrated globally, with low tariff barriers and fast rising trade/GDP ratio. By virtually pegging its currency to the falling dollar, India is also importing the associated inflation.

Over the past year ending April 19, 2008, food articles and products, minerals and mineral oils, iron ore, iron and steel account for two-thirds of WPI inflation in India. Oilseeds and oil cakes, mineral oils, iron ore, iron and steel, with a combined weight of just 15% in the WPI index, alone account for 57% of the increase.

Global consumer price inflation has risen sharply the world over. According to The Economist, consumer price inflation in the US rose from 2.8% in March 2007 to 4% in March 2008. The corresponding increase in the euro area was from 1.9% to 3.9% and in Japan from -.2% to 1%. Bric countries have fared much worse, with CPI inflation rising from 3% to 4.7% in Brazil, from 7.4% to 13.3% in Russia and from 3.3% to 8.8% in China. In sharp contrast, CPI inflation for industrial workers in India fell from 7.6% to 5.5%. The rise in domestic inflation is relatively modest by global benchmarks on account of rupee appreciation, monetary tightening and because India is more or less self-sufficient in food, Indian agricultural markets are not well integrated either nationally or globally, and POL prices are administered.

Money supply has been growing at around 21% in the last three financial years, about 4% above what is necessary to ensure price stability. Most of this increase is on account of FDI and FII inflows, only part of which could be impounded through sterilisation and increase in reserve money. Of the $299 billion of forex assets with RBI as on March 28, over a third was added during the last financial year alone.

Nothing can be done about the base effect and global inflation, and there is little space to use fiscal policy without serious fallout on inflation over the medium term. That leaves monetary and exchange rate policies, apart from boosting supply over the medium term. While monetary tightening and exchange rate appreciation could affect growth in the short run, there is no long-term trade off between growth and price stability, since high inflation dampens growth.