Price of change

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With the weekly inflation reading crossing 11% on Friday, RBI has hiked the policy rate another 50 bp, following a 25 bp hike two weeks ago. It appears that, after this aggressive move, only a limited additional tightening will be needed to stabilise the economy. This largely reflects the nature of the growth acceleration of the past few years.

As stressed by RBI, inflation does not just reflect higher global oil prices. The price of petroleum products increased by 25% in the year to June 2007, which, of course, reflected the recent increase in retail oil prices. And because the WPI is mainly composed of commodities or commodities intensive goods such as metal products, WPI-based inflation reflects mainly commodities price trends. However, since early April, the prices of manufactured goods such as machinery and machine tools or transport equipments have started to trend up. There is a risk that commodities driven price inflation could be spreading to other components of the price index as it is in a number of other Asian countries.

The acceleration in the price of manufactured goods suggests India could be experiencing resource pressures. Indian manufacturers, who by now have endured several years of rising cost of energy and raw materials, may have started to pass these on to their customers. This pricing power likely reflects the strength of domestic demand: FY08 growth was 9%, only slightly below the record high growth of 9.6% in FY07. And, of course, the weakening of the rupee since early April has raised the price of imports, which has given Indian manufacturers additional room to raise their prices.

So bringing down inflation may well require growth to slow to such an extent that manufacturers feel that their customers no longer have enough purchasing power to absorb price increases. Without slower growth on the other hand, there is a risk that inflation could continue to accelerate. India, like other countries that are net importers of commodities, is going through a terms of trade shock. Higher prices of energy and raw materials have reduced India’s income and domestic demand needs to adjust to this new reality.