Supply-side bottlenecks probably contributed more to inflation
This article is a rejoinder to the ongoing debate in FE regarding the contribution of procurement prices to the overall inflation rate. This debate assumes particular importance in the context of a recent article (?Procurement price inflation bogey?, FE, March 28, http://goo.gl/M7jdX). The primary argument of this column is, given that commodities without minimum support prices (MSP) have been witness to price rises larger than commodities with MSP, it is foolhardy to conclude that the increase in MSP is responsible for price rise. Subsequently, the column goes on to argue that lax monetary policy is to blame for increase in prices, and not MSP. While the second part of the argument looks a little bit preposterous (it is anybody?s guess that we have been following a tight monetary policy since March 2010, with the LAF almost at a perpetual deficit coupled with OMO injections by RBI), we are also not convinced regarding the correctness of the first part, as it has completely missed the finer point. Let?s see how.
First, the link between increases in MSP and WPI. We propose that apart from a direct impact of MSP increases on WPI (MSP linked commodities in primary articles basket have a weight of 7.3% and our estimates show that, on average, such items have contributed 33% of the increase in primary articles in the last five years), there is also an indirect impact. This is the increase in MSP acting as a floor to WPI inflation and thereby feeding into an expectation of an all-pervasive increase in food prices. For example, our analysis shows a clear spike in prices of primary articles in the months of October and January-March just ahead/in sync of/with the MSP announcement.
However, a small caveat here. As table 1 shows, while it is clear that increases in MSP are acting as a floor at least for cereals (10.8% vis-?-vis 11.6%), thereby supporting our contention, increases in MSP for pulses have far outstripped the WPI increases for the same over the same period. This shows that MSP increases may be one of the reasons for current price increase but not the only one. However, as indicated earlier, the arguments to establish this causation are entirely different from what was argued in the FE column.
We decomposed the primary articles (weight ~20.11) into two components: commodities linked to MSP (weight ~7.30) and commodities not linked to MSP (weight ~12.81). Further, commodities not linked to MSP have two sub-categories: linked to food (weight ~10.24: fruits & vegetables, milk, eggs, meat & fish, condiments & spices and others) and other than food (weight ~2.56: non-food articles, flowers, minerals, crude petroleum, etc). As evident from the diagram, the contribution of food articles (not linked to MSP) has been the maximum in primary articles (on an average, 74% of the increase in prices of primary articles could be explained over the five-year period ended FY13 by food items). On the other hand, if we look at items other than food, these have actually negatively contributed to primary articles inflation (7% decline to weighted contribution). Alternatively, most of these items have an insignificant weightage (for example, linseed has a weightage of only 0.008, the prices of which have increased by 36%, coriander has a weightage of 0.02, the prices of which increased by 73.4%, as per the column) in the overall consumption pattern on consumers and, hence, even if the prices may have increased significantly (as pointed out in the column), at the margin, they have actually contributed negatively to primary articles inflation! Interestingly, some of the items mentioned in the column also belong to manufactured food products (gur has a weightage of 0.07, the prices of which increased by 127.4%), but the bottom line remains the same, insignificant weight. Hence, what is important is the contribution of items without MSP (apart from food) to inflation, rather than the absolute increase. To look at absolute increases is misleading.
Regarding the second point, as table 2 shows, RBI has been following a contractionary monetary policy since March 2010, and the M3 actuals have consistently fallen short of the targets. Thus, it is difficult to comprehend how the monetary policy was expansionary. We don?t want to touch upon other aspects like the linkage between fiscal slippage and monetary expansion, as we believe these could take up another column. However, in a situation of tightening monetary policy, OMO purchases may not have impacted monetary expansion (refer table 2).
The enormous contribution of food items in inflation substantiates that inflation in recent times has not been only a monetary phenomenon but explained by supply-side logistics. Enough has been written and debated on it, and we don?t want to say more. However, we would like to point out the conduct of monetary policy against such a background.
There is now a growing debate in India regarding the efficacy of monetary policy in the evolving growth scenario. In effect, we believe that the monetary policy conduct in India is being increasingly dictated by exogenous factors?a classic resemblance to the monetary policy quadrilemma (ability to accomplish only two policy objectives out of financial integration, exchange rate stability, monetary autonomy and financial stability). Consider this example. In the last fiscal, RBI foreign exchange intervention (including in the forward market) has sucked out liquidity to the extent of R90,000 crore. This, we believe, has been one of the reasons for liquidity tightening in the last fiscal (as also in the previous couple of years). Thus, defending the rupee has had a cost, and this is exactly the policy quadrilemma RBI is currently facing. We extend the hypothesis (perhaps an apt topic for future research) of policy quadrilemma to policy pentilemma by arguing that structural bottlenecks on the supply-side are the fifth factor inhibiting the smooth conduct of monetary policy in India.
Soumya Kanti Ghosh is senior fellow, Icrier. Sakshi Arora is an independent researcher. Views are personal