Structural changes, capacity building needed to tame food inflation. Or crush non-food inflation
Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.
—Mervyn King, former Governor, Bank of England
On the surface, the Union Budget for FY16 looks positive for inflation. This resonated in the rate cut by RBI within a week of tabling of the Budget in Parliament. But as far as the realities go, many stones need to be turned for India to enjoy sustained spells of low inflation outlined in the new monetary policy framework.
The agreement between the Centre and RBI on a monetary policy framework underscores the glide path on prices starting with 6% by January 2016. For subsequent years, the target has been set at 4% with a band of ±2% as recommended by the Urjit Patel Committee. The framework also entails that RBI will, every 6 months, provide details on the sources of inflation and its forecasts for 6 to 18 months.
‘Failure’ has been defined as inflation deviating from the target for three consecutive quarters. Just the way it is for the US Federal Reserve and Bank of England, RBI will have to explain to the government reasons for the deviation, and propose remedial action and the timeline to achieve the target.
Sure, this will lead to greater transparency and predictability on central bank action. It will also help steer inflation expectations and thereby reduce volatility. Another positive spillover will be greater predictability on wage growth, government yields and purchase decisions by consumers.
In addition to the new framework, the commitment towards high-quality fiscal consolidation with a lower target of 3.9% of GDP for FY16 from 4.1% this fiscal, is in accordance with the expectations of RBI. The focus of the Budget is on investment growth than consumption demand. Also, while service tax has been increased to 14%, its impact on inflation is seen limited because of a commensurate decline in demand for these items. International experience and research by Bank of Canada also shows that increase in indirect taxes leads to a temporary rise in price level beyond which the inflation rate is unaffected.
Overall, the refrain is the Budget is non-inflationary. And on greater fiscal and monetary coordination, steps announced in the Budget get 10 out of 10.
Now, for the reality check. Under the new consumer price inflation series, the weight of food items is at 39%, while that of non-food items is 61%. On average this fiscal, food inflation has been above 7%. Though this is much lower than the double-digit figures of the last few years, it still makes achieving the inflation target of 4% challenging. For overall inflation to be at 4% and given current food inflation at 7%, non-food inflation will have to plunge to 2.1%, or half the all-time low of 4.4% seen recently, and nearly a third of this fiscal’s average of 6%. Importantly, these numbers have come in times of weak growth. As the economy picks up, crunching non-food inflation further will become increasingly difficult.
When food inflation reaches historical highs (close to 10%), non-food inflation will have to be squeezed to 0.2% to 3.4% to get overall inflation between 4% – 6%. This will be a tall order as demand builds up in the economy. Therefore, while the target of 6% for next year is achievable, squeezing inflation beyond that will require structural changes.
The steps taken to build capacity have so far been piecemeal. Efforts to push farm productivity have been inadequate. The Budget this time—just as in the last fiscal—has allotted funds for schemes such as the Soil Health Card, Rural Infrastructure Development Fund (R250 billion), Long-Term Rural Credit Fund (R150 billion) and Short-Term Cooperative Rural Credit Refinance Fund (R450 billion). It also announced allocation of R53 billion under the Pradhan Mantri’s Gram Sinchai Yojana aimed at irrigation and improving water use efficiency—but this is considerably lower than last year.
While these steps are in the right direction, they are not enough to push agriculture growth close to 4%, which is the medium-term target. The allocation for the ministry of agriculture and allied activities is similar to the levels seen in FY15. Data show total expenditure on agriculture and allied activities (crop and animal husbandry, soil and water conversation, dairy development, food storage and rural development) by the Centre and the states has declined from 7.5% of the total expenditure in FY91 to 6.6% in FY14—even as the size of the economy has multiplied 4 times in the same period.
On their part, states will need to do the heavy lifting to change the game in agriculture. In most farm programmes, funds allocated by Centre are low and states are expected to plug the gap. In the Budget, the share of state expenditure on agriculture and food processing industries was pegged at 58%, compared with Centre’s 42%, implying where the onus lies.
The Budget also did not further build on measures to improve the food-supply chain—such as steps to improve warehousing and storage infrastructure, progress towards a National Agricultural Market announced in the previous budget, developments on the previously announced protein revolution, and establishing a price stabilisation fund of R5 billion.
That being the predicament, it may well be the case that RBI’s success on inflation targeting will depend a lot on the states, going forward.
Joshi is chief economist and Gupta is economist, Crisil. Views are personal