Prices rise when demand gets ahead of supply. In the real world, this happens mostly when there is some kind of supply constraint?demand growth is a more well-behaved and predictable animal. A little bit of inflation is useful to keep the cogs of the economy lubricated and investments flowing, since real rates of return remain attractive in a world where positive nominal interest rates prevail. But too much is unacceptable. Like a thief in the night, it eats into real incomes and monetary savings of ordinary people; it severely alters terms and trade and injects all manner of uncertainties into the economy, besides igniting political and social tension.
After the decade of high inflation of the 70s and 80s, in the OECD nations the consensus has looked at 2% as an acceptable inflation rate. In developing countries, which traditionally have had higher rates of inflation (and, hence, constantly depreciating currencies), there has been a gradual transition towards a regime of more stable and lower rates of inflation. Latin America was able to move from an era of hyper-inflation (rates in the hundreds of per cent) to fairly stable conditions over the past decade. High inflation came to India courtesy of the widespread shortages during the second world war, and found accommodation in ?inflation tax? being viewed by some as a real and legitimate resource. Since the mid-1950s, the era of 3-3.5% rate of growth came in the inextricable company of 6-7% inflation. India has certainly travelled a long distance to have got to 7.5-8.5% growth with 4-5% inflation.
Globalisation has enabled trade to build on the large variations in comparative advantage across countries on an unprecedented scale. It has constructed a powerful supply chain that is able to keep up well with global demand growth and, hence, generate low and stable inflation rates. In the domestic sphere in the developed West, few bottlenecks impede expansion of activity, resulting in a very slow rise in the prices of services?housing, education, health care.
But the one thing where there is a big supply constraint is petroleum and, to a lesser extent, other mineral products. The story of petroleum is not only of a depleting resource, but also a business where much of the cheaper resources are cartelised under the multinational Opec. Like all monopolies, high prices are maintained by abjuring output augmentation, i.e. exploration and development. The increase in demand from China took the industry by surprise in 2002/2003 and caused prices to soar to levels that had only existed in the daydreams of Opec. In response to high prices, demand normally adjusts through curtailment. While that may have worked to an extent in the OECD region and elsewhere, in China it failed to make an impact, as fuel prices (unburdened by any tax) were amongst the lowest, outside of some Opec countries, and the government was unwilling (till recently) to let prices adjust upwards.
But that wasn?t the only factor which allowed oil prices to keep rising and remain at such high levels and for so long. The most remarkable thing about the past few years has been the ability of much of the world to maintain high levels of economic growth with low levels of inflation, despite oil prices.
? Globalisation has constructed a powerful supply chain to handle demand ? The one big exception, apart from some mineral products, is petroleum ? In India, oil is only one of many areas lacking market mechanisms |
In May 2006, US producer price inflation (PPI) was at 6.2%, with the pervious six months averaging 7.1%. Industrial producer prices in the Euro-zone increased by 6% in May and by 12.1% in the UK. Manufacturing input prices increased by 14.5% in the Jan-March quarter, according to the Bank of England. Consumer price inflation has been lower, since energy has a smaller weight in the index. In May 2006, the energy component of the US CPI was up by 24%, year-on-year, and the Euro-zone CPI by 19%. In the UK between March and May, domestic gas prices have risen by 20% and of electricity by 15%.
Several things emerge out of his.
First, given that the PPI inflation rate bears a reasonably close resemblance to our WPI rate, it does not show up our 4.8-5.4% WPI inflation rate in too poor a light. Second, it raises the question of fully understanding why non-energy inflation through the developed world is not much higher than it has been. Third, it obviously raises the possibility that the full pass-through of energy price increases to the rest of the economy has yet to happen. Fourth, if there is a big pass-through waiting to happen, it cannot be ruled out that the adjustment will happen in conditions of depressed growth, if not outright recession.
In India, it is true that we have prevented the full increase in oil prices to be transmitted to the economy through the price mechanism. Instead, we have chosen to absorb much of the price effect by the financial debilitation of state oil companies and absorbing a fiscal burden? all of which will have their own inevitable pass-through effects.
But the potential of a prospective price pass-through still looms substantially, even if oil prices rise no further and we are able to drag the process out over a number of years. In the developed world, the price pass-through has been synchronous with the increase in oil prices and it is now four years since these began to rise, making the prospect of an accumulating shock further down the road look unlikely. But for us in India, it is not only oil where there is a supply constraint. There are, indeed, many others: from electricity to roads to airports to ocean ports to drinking water to municipal services to education to farm productivity. Like oil, the market mechanism in these areas works inadequately or not at all.
In India, aside from oil, it has been some food items?wheat, pulses and vegetables?that have pushed inflation up. It is relevant to note that unlike manufacturing, our agricultural sector has not benefitted from the process of liberalisation. This makes our vulnerability to inflationary risk higher than it would have otherwise.
?The writer is economic advisor, Icra
