Public discourse often discussed if the low retail food inflation observed until about a year ago was cyclical or structural.
At 6.9% in July, the high CPI inflation is making everyone nervous. The bond market is already panicking—yields on the 10-year benchmark paper jumped close to 35 basis points in the last fortnight. Macroeconomic instability at this critical juncture is the last thing the economy can ill afford. There are many economists, including this author, who believed the government had more room to spend to support faltering growth. Some continue to advocate the government should borrow directly from RBI, if required. The chief economic adviser had stated some time ago that there could be a second round of stimulus at the appropriate time. But, if high inflation persists in the months ahead, such measures would be off the table.
The minutes of the August 6 MPC meeting reveal the high anxiety of some members over inflation even before the mid-August release of July CPI data. Many still harbour hope that the inflation surge could be temporary, driven by supply-side constraints; things would normalise in the second half of FY21 as economic activities return. However, most analysts have agreed the probability of an October policy rate reduction is now remote. Inflation forecast errors, particularly of food prices, are magnifying with each passing month. Deputy governor Patra in particular worries, if food prices—the ‘true core’ of inflation dynamics—have gained a toehold that could spill over to generalised inflation.
In the last six years, the Modi government has established a reputation and earned praise for its proactive or even aggressive supply management that brought down food inflation, created the base for the success of RBI’s flexible inflation targeting (FIT) regime. Persistently high food inflation since November 2019, averaging 10.8% (excluding April-May 2020), could puncture that claim. It could even halt the interest rate easing cycle midway and push the economy into stagflation at a very delicate time of the still-spreading Covid-19 infections. The needle could easily rewind to 2009-10 when a large fiscal deficit and easy money wreaked havoc upon macroeconomic stability and growth in subsequent years. The stakes are very high!
Views in support of supply-side constraints underlying food inflation abound. If indeed inflation will autocorrect once activities normalise, given the subdued demand conditions, why should we worry? There is but one caution: Food inflation was high even before Covid-19 and did not correct in line with RBI’s expectation in the Jan-March 2020 quarter. Even if the post-Covid high food prices are largely attributed to supply constraints caused by lockdowns, the real risk is the persistence and its impact on expectations getting entrenched.
To what extent should we accept the supply side explanations? Where are the evidences in support of supply constraints? Some offer the large divergence between CPI and WPI food inflation as clinching proof, mostly ignoring the fact that such gaps have been recurring in the recent past. Market imperfections at the retail end have long been the bane of India’s food price story. We had, in the past, argued for allowing big FDI into this segment to increase efficiency and competition in the supply chain. This policy gap still remains unaddressed.
In the absence of competition, retailers can be sharks. Consider, for instance, the prices of cereals. The country is overflowing with rice and wheat stocks. The government is on a massive distribution spree of free rice and wheat to nearly 800 million people since March 26. This is an extraordinary market intervention by any measure, anywhere in the world. Add to this the demand withdrawal from hotels & restaurants and prospects of another good kharif crop. Yet, cereal prices did not crash!
The high pulses prices warrant more scrutiny. The government is also distributing free pulses of limited quantity (1 kg each per family). But, there is no sign of prices easing. In fact, the prices of pulses increased in double digits (average 15%) in Oct-March or before Covid-19. However, the government was lacking in its characteristic aggressive supply management as in the past. Pulses stocks were inadequate for effective market interventions, and no imports were planned to augment domestic supply either.
Not surprisingly, Governor Das suggested in the MPC minutes that the government must conduct more open market sales of cereals, import pulses and edible oils to bridge the domestic supply deficit and ease pricing pressures. It isn’t clear why the government hasn’t taken steps in this direction until now. Perhaps, placing import orders might have been difficult during the pandemic. It could also be the political economy reasons, viz. allow farmers to gain under the new agriculture reforms to fulfil the ‘doubling-farmer-incomes’ promise. If so, this could be a parallel to the UPA government’s manoeuvre of terms-of-trade towards agriculture through successive MSP increases each year. But the consequences, let’s not forget, turned out to be an economic disaster!
Apart from high CPI, WPI for food items has also ruled higher relative to its past—these were negative in most months of FY19. This could be reflecting some element of cost-push, especially high diesel and fertiliser prices. It is worth recounting that both government and consumers, including farmers, benefited enormously from global oil price crash in 2015-16. But unfortunately, in the current Covid oil price crash, similar space is fully exhausted by central and state governments raising fuel taxes, thus forcing farmers to pass on costs entirely. This upward thrust to base prices could have been bigger factors than supply constraints.
Public discourse often discussed if the low retail food inflation observed until about a year ago was cyclical or structural. Perhaps the government believed it was structural, becoming complacent in its supply management. But, the needle seems to have turned full circle! The food price trends raise suspicion if the old pricing dynamics, in which retail food prices retained or increased margins irrespective of supply conditions, are back to haunt.
It would be imprudent to relax and hope that prices will self-correct once supply rigidities ease ahead. If elements other than supply shortages have already gained a grip, then transmission risks to general inflation could force an untimely reversal in monetary actions. RBI appeared ambivalent if to conduct more open market operations (OMOs) in the light of apprehensions expressed in the MPC minutes on the role of monetary factors in fanning inflation. However, the central bank has now gone ahead and announced OMOs to cool down the overheated bond market. But for a durable impact on yields, the government will have to deploy its full supply management skills to rein in food prices.
The author is New Delhi based macroeconomist
Views are personal