What are the consequences of the floating vs administered regime (in petroleum products) for the level and volatility of inflation? There are fears that inflation will go up, or the volatility of inflation will go up, if we move to a system where product prices fluctuate every day. There are three interesting aspects to this problem.
First, since administered prices have to ultimately be adjusted to catch up with the random walk, the two alternatives really only constitute a choice between a large number of small adjustments versus a small number of big adjustments. It is likely that administered pricing involves bigger macroeconomic shocks to the system. As the experience of ending administered pricing of cement and steel suggests, the economy adjusted quite well to the idea that the price of cement or steel fluctuates every day. There is no reason why this could not happen to the price of petroleum products.
The second point is about measurement. In our intuition, we think of the CPI as a weighted average of a bunch of prices. The moment petroleum product prices go up, the CPI goes up. This is the first order inflationary impact of the rise in prices of petroleum products. This intuition is flawed.
The true inflationary impact of a rise in the price of any one commodity (eg, petrol) is smaller than it appears, because households have an overall budget constraint and switch consumption away from more expensive petrol to other commodities.
The standard microeconomic response?through substitution and income effects?generates higher payments for petrol and lower payments for all other commodities. The quantities of petrol versus other commodities change in response to a price hike in petrol. The reduced demand for other commodities induces somewhat lower prices for those.
A general equilibrium analysis is required, and the result differs substantially from the partial equilibrium calculation that is embedded in the computation of the WPI or the CPI, where the weights are held fixed and only prices change. Computation of the CPI with a fixed set of weights misses out on the adjustments of households and overstates inflation.
The third point which deserves attention is the macroeconomic dimensions of the transmission of a rise in petroleum product prices into broad-based inflation. When consumers see a rise in inflation caused by a rise in petroleum product prices (or vice versa), how do they react? Do households demand higher wages? Do firms pass on price increases? Do inflationary expectations get built up, and do we get an inflationary spiral? The extent to which this takes place is critically about the information set of households, the monetary policy framework, and the credibility of price stability.
Monetary policy in India from governor Rangarajan onwards has increasingly focused on price stability as a major goal. This approach has been underlined by the Percy Mistry and Raghuram Rajan committee reports, and is reflected in the strong expectations in the broader economy that the foremost task of RBI is to work towards price stability. With the passage of time, RBI would gain credibility as being focused on delivering low and stable inflation. In this case, households and firms would know that the central bank will deliver on stable inflation in the medium term. In this case, households and firms are less likely to react to short-term small fluctuations in inflation through wage hikes or increases in product prices.
As the Kirit Parikh report says: ?4.13 With deregulated oil prices, once households and firms clearly see that international factors drive domestic petroleum product prices, and when monetary policy is seen to emphasise price stability, households and firms would be relatively relaxed. When there is a temporary shock to oil prices, they would be much less likely to react to short-term fluctuations in prices through wage hikes or increases in product prices. Thus, in OECD countries, from 1979 onwards, where central banks have shifted into de facto or de jure ?inflation targeting?, the great commodity inflation from 2002 onwards did not pass through into broad-based inflation in the 2002-08 period.?
We should decontrol petroleum product prices right away because this makes much sense. In the short run, while India has not yet perfected the institutional mechanism of monetary policy, this will yield somewhat increased volatility of inflation in the short run (while avoiding the big shocks to inflation when administered prices were adjusted by large amounts). In the future, when the institutional capability of monetary policy improves, we will reap the benefits of this in terms of households and firms being more likely to take global commodity price fluctuations in their stride.
More generally, a sophisticated monetary policy capability is an integral part of the market economy. Infirmities in the market economy (eg, the lack of a bond market or capital controls) inhibit the effectiveness of monetary policy. Infirmities in monetary policy (eg, lack of de jure inflation targeting) inhibit other reforms such as ending administered pricing for petroleum products.
(Concluded)
The author is an economist with interests in finance, pensions and macroeconomics
