To target anything lower, while a theoretical possibility, may not provide proper guidance for monetary policy formulation as the number would be hard to sustain
With inflation once again remaining fairly sticky in the 5.5% range, a question that can be asked is, whether targeting a CPI inflation rate of 4% looks reasonable given our past experiences? Inflation in India has always been unpredictable, with both internal and external factors influencing this number. While oil prices are a known variable when it comes to driving inflation, other commodity prices driven by global factors have surfaced in the last two years, sending conflicting signals through the inflation indices. At the same time, domestic shocks have emanated from products such as onions, often leaving us helpless in terms of policy response.
Conventionally, one could always say that the WPI and the CPI moved together, with the thumb rule being that the difference would be 2% points. Normally, the CPI would rein higher than the WPI. The former is a retail price index and the latter closer to a producer price index. The two indices differ in terms of weights given to various components, besides these constituents being different. The WPI includes machinery, metals, etc, which do not feature in the CPI. The latter, in fact, is dominated by food products, clothing, travel, rent, recreation, etc. Given the long value chain in the system, retail prices are always higher than wholesale prices and tend to increase more than proportionately as margins get enhanced during an upswing in prices.
In the last three years, things have changed, with the differential between the two indices increasing at the rate of 3% in FY13, 3.7% in FY14 and 4.3% in FY15. For FY16, the differential is above 5%, with the WPI indicating a negative number. This has caused different emotions, with no one being happy. Consumers still complain that prices are high, and inflation of food items has denuded the purchasing power and demand for non-food products, which is reflected by the low growth in industry. Producers have been affected by declining prices, which has impacted their profitability. While both raw material cost and final prices have declined, they have witnessed a sharper drop in prices of their products. How exactly can we interpret inflation?
In India, inflation is necessary and inevitable to keep business ticking. It has been observed that prices should increase by at least 2-3% on an annual basis for manufacturing to provide incentive to produce and make profit. Therefore, deflation is definitely not a good sign for industry even though it provides comfort for policy-makers. Consumer prices, on the other hand, are bound to increase by at least 5% on an average basis and anything lower would be by chance only.
Data for the last 10 years indicate that CPI inflation, going by a combination of the index for industrial workers and the new CPI with base of 2012, was above 5% in nine of the 10 years, with FY06 being an exception, at 4.4%. On three occasions it crossed the double-digit mark and two others ranged between 9-10%. Hence, to expect CPI inflation to fall to less than 5% on a continuous basis would be extending optimism. More so because the factors that have led to this relatively high range of inflation are driven by circumstances over which the government and RBI have little control. There are reasons for this.
First, CPI inflation is affected mainly by what happens in the farm sector. The behaviour of the monsoon and the outcome of the two crops, rabi and kharif, will have a major bearing on how these prices move. Further, prices tend to react to news on crop prospects, and given that the monsoon rains have now become erratic across various regions (even if the overall number is normal), prices have become volatile.
Second, it has been observed that specific price shocks have caused considerable increases in consumer prices. It could be pulses this year, or onions, tomatoes or potatoes on others. Excessive monsoon rains or damage to crops could cause considerable increase in prices, even with an otherwise normal harvest and low inflation for other crops.
Third, the MSP issue has been contentious as it rakes up the debate between interests of farmers and consumers. While the government has tried to moderate the increases in these prices, at times it may not be possible to control these hikes as farm productivity and interest in agriculture has been dwindling over time. This factor would continue to exert pressure on the CPI food inflation index.
Fourth, we have now moved over from a controlled regime for prices of petrol and diesel to the one that is market-determined. Here again, these prices have become volatile for two reasons. One, while the global crude oil prices are low today, any increase in price would automatically get reflected in the CPI both through fuel inflation as well as indirectly through the transport and travel components. Public transport and taxi fares once increased never return to the earlier levels. Two, given the state of markets, the rupee has also been susceptible to depreciation, which, in turn, increases the prices of fuel products that are not controlled. As the government works towards moving away from the system of providing subsidy on fuel products or minimising the same, the prices would tend to go only in the upward direction.
On the other side, global commodity prices, which have played a critical role in lowering producer prices in the last two years—especially of metals, fertilisers, metal products, machinery, etc—can be reversed once the world economy turns around. This would tend to push up prices of manufactured goods within the WPI and indirectly to a lesser extent on the CPI.
To conclude, it may be stated that there is a bit of uncertainty in the global markets right now, and with a strong likelihood of volatility in the domestic market for food products, inflation is bound to be relatively high compared with those of developed countries. Hence, while 2% is the norm which is used by the US Federal Reserve or the European Central Bank to target inflation and hence monetary policy, in our context the threshold has to be higher.
The current level of 5-6% looks realistic as anything higher could cause pain. However, to target anything lower, while a theoretical possibility, may not provide proper guidance for monetary policy formulation as the number would be hard to achieve and sustain. And more importantly, almost 80-85% of the index is not affected significantly by interest rates.
The author is chief economist, CARE Ratings. Views are personal