The Hindu Business Line : Inflation overhang

Despite warning signals, the RBI did not see any immediate effect of the high money supply on inflation, little realising that there is always a time lag between the burgeoning of money supply and rise in the rate of inflation. How the Government will steer the economy away from the danger of price instability remains to be seen, says B. S. Raghavan.

IMAGINE yourself to be the common man, but intelligent and curious.

Suppose you want to know why the annual point-to-point rate of inflation for the week ended July 24 had shot up to 7.51 per cent as against the assumption of the Reserve Bank of India (RBI) some months ago that it will remain at a benign range of 4-4.5.

Suppose you ask the Finance Minister and the RBI Governor, whose business it was to be in the know of such things, why they are now wringing their hands and saying that it was "totally unexpected and unanticipated".

You will be up against an inflation of explanations.

A sampler

It is "imported" or petro inflation, thanks to the rise in the global oil prices from an average of $22 per barrel at this time last year to $39 per barrel now.

It is "primary" or "primary product" inflation running inexplicably high defying the "contraction in the primary product index in the last four weeks".

It is "manufacturing" inflation, meaning a jump by about 19.5 per cent in the prices of basic metal alloys and metal products.

It is "international" inflation, since almost 45 per cent of the price rise being witnessed is a result of international factors.

It is "commodities" inflation with particular reference to higher prices of steel and cement on account of China furiously purchasing massive quantities for construction of infrastructure for the 2008 Olympics.

It is "seasonal" inflation, normal at this time of the year due to rise in the prices of fruits and vegetables aggravated by uncertainties over the setting in of monsoon.

It is inflation caused by "liquidity overhang" and money supply in the country vaulting over the safe ceiling of 14 per cent to come close to 17 per cent because of the failure to mop up the excess in time.

It is "composite" inflation, being the combination of a bit of all the above.

Disconcerting situation

This is what in medical parlance is called differential diagnosis. It could be this, or that, or a third one, for symptoms of many different kinds of ailments overlap, and the only way to untangle them is to carry out a variety of tests and scans, and rule out the possibilities one by one. Until then, the prognosis also takes on conflicting complexions — some inconsequential, some serious, some grave, some terminal. Similarly, the prognostications on the likely course of the disconcerting situation that has everyone on tenterhooks have also been widely varying.

India has shown, so runs one comforting scenario, sufficient resilience in absorbing past oil price shocks, and this time too, it may ride it out. In any case, we have it on the authority of Dr Ian Jacobs, Senior International Economist and Strategist of Sydney-based AMP Capital, that a fall in the global growth rate from around 4 per cent as of now to 3 is on the cards, and this is bound to bring down oil prices in its wake. Even a price of $45-50 per barrel would be sustainable over a period of three-five years. According to him, one need not worry about higher commodity prices also, as they would lead to higher investment and prove beneficial for at least some smaller emerging economies.

According to the Finance Minister, Mr P. Chidambaram, an inflation rate of 7.5 or 8 is not uncommon. The commodity prices may go up and down, but what is significant is that while there has been a spurt in the wholesale price index to 7.5 per cent, the consumer price index has remained at around three per cent for a long time. So, people can persuade themselves that there has been no major surge in price levels.

Actually, by September "things will settle down". Both the RBI and the Government would take "measured steps" on the monetary and fiscal fronts and "there will be no panic or knee-jerk reaction".

Merrill Lynch too has got into the act with its own rather obfuscated but optimistic predictions. It posits the fall of inflation to 5.6 per cent by March 2005 based on its expectation of a halving of fuel inflation from 10 per cent at present to 5.5 by the year-end and a primary inflation of 8.6 per cent. Inflation, as per its computation, will remain above 7 per cent throughout August, peak to 7.9 per cent in September, and average out to 6.2 per cent for the whole fiscal 2004-05.

Awkward predicament

Time will tell whether these assurances fall within the realm of astrology, numerology or economic logic. What is clear is the awkward predicament of the new United Progressive Alliance Government, with stalwarts such as Dr Manmohan Singh, Mr P. Chidambaram and Dr Montek Singh Ahluwalia in pivotal positions to steer the economy away from the danger of price instability, giving the impression of letting events take them by surprise.

Added to that, the one agency, the RBI, on which falls the onus of keeping a rigorous, professional vigil on the price front and drawing on its armoury of weapons to ward off the ugly prospect of uncontrolled inflationary impact on the economy, can only be said to have woken up late.

Fire-fighting in the best of times is messy business; it becomes messier when caught in the throes of the psychological repercussions in the form of acute embarrassment to the Government and the fear of inflation feeding on itself and pushing up prices higher.

That for four months since November 1, 2003, money supply (M3) was growing by 6 per cent, giving an annualised growth rate of 18 per cent, much above the figure of 14 per cent adopted as a wake-up alarm, ought to have been a matter concern to the RBI. The net foreign exchange assets of the banking industry had registered a steep increase from 26.2 per cent in the same month the previous year to 33.9 per cent in March 2004, of which a whopping 53 per cent rise occurred in just four months alone. Even at that time, economists had drawn attention to the need to sterilise the influx of dollars by prevailing on the Government to issue market stabilisation bonds of a commensurate amount to mop up the liquidity.

The RBI was, however, resting on its oars since it did not see any immediate effect of the high money supply on inflation, little realising that there was always a time lag between the burgeoning of money supply and rise in the rate of inflation. Again, warnings at the time, now proved accurate, to the effect that a rise in prices later on in 2004-05 was inevitable, were not wanting.

True, any intervention on the scale needed might have ended up in a vicious circle: It might have jacked up the interest rates, which would have further acted as a magnet for more foreign capital, requiring still more vigorous efforts for mopping up excess liquidity. But to arrive at the right trade-off between various hard options is precisely the job expected of the RBI.

Laidback assessment

Instead of being on the ball, the RBI was misinterpreting the signs during the critical period. This is evident from the observations relating to the topic made by the RBI Governor, Mr Y. V. Reddy, in his address to the Federation of Indian Chambers of Commerce and Industry in January 2004.

After pointing to certain adverse trends such as the rising prices of oil and primary commodities and the "probability of international transmission of inflation", he went on to say: "At the same time, there are three favourable factors to counter these recent adverse global developments. First, in the normal course, it is expected that the inflation rate would fall in the period mid-January to March 2004. Second, there are cushions in terms of food stocks and ample forex reserves. Third, our economy has, in recent years, shown remarkable resilience in absorbing shocks including on the oil front.

"In view of all these factors, it is possible that the downward bias may not be attainable but it appears that the range of 4-4.5 per cent for inflation indicated in the Mid-Term Review continues to be relevant for policy purposes unless there are unanticipated severe shocks.

"It may be noticed that the policy assumption in April 2003 was 5.0-5.5 per cent and the latest assessment placing it in the range of 4.0-4.5 per cent demonstrates that, overall, inflationary situation continues to be benign for 2003-04."

It was this somewhat laidback assessment that was perhaps responsible for the apparent lack of vigour and drive in taking measures to forestall the emergence of what is now plain for all to see.

Elusive dimension

There is one elusive dimension of inflation that is amenable to neither monetary nor fiscal correctives, but only to the application of all the political will that the Government as a whole can muster.

It hardly figures among the explanations, because the very mention of it is construed as politically incorrect. This is about the distinct possibility of the overheating of the domestic demand not because too much money is chasing too few goods, but because so many have come by so much affluence within so short a time that they are only too willing to pay whatever price is asked for whatever good or service, and thereby contribute to soaring prices.

The Government must boldly veto any further talk of Pay Commission or pay increase for the nearly three crore living it up in the organised sector (including the Central and State Governments), without being subjected to any stringent productivity criteria.