Inflation eases, but threat persists

The latest data on WPI inflation falling to a three-year low of 6.62 per cent in January 2013 has brought cheer to policymakers. There is an emerging chorus in the media celebrating the anticipated victory over inflation.

Prior to this, in distant 2009, inflation was generally low with a couple of months of negative inflation (June-July 2009).

The easing of inflation in January 2013 is also consistent with the RBI’s projected trajectory, as per the guidance provided in the October policy review.

Premature conclusion

Not only has the recent reduction in inflation been welcomed by all, the expectation of further rate cuts by the RBI among some sections has increased -- with the central bank seemingly better placed to handle the growth versus price stability conflict. However, before acting in haste, there is need to be cautious.

As Chart 1 shows, the line with dashes depicts average year-on-year WPI inflation for various months during 2006-12.

As inflation figures in most of the months in 2009 were generally outliers, the smooth line was drawn based on the average inflation for the respective months excluding those in 2009.

It can be observed that, in general, inflation has been showing a strong seasonal pattern with low inflation during November-February and high inflation during March-October.

Thus, there is a need to confirm inflation easing with appropriate economic and technical analysis; any premature monetary accommodation should not encounter surprise inflation in mid-2013.

Among important indicators, deceleration of broad money growth to 12.9 per cent in January 2013 as compared 15.7 per cent a year ago, is commensurate with current inflation easing, but growth in bank credit to the commercial sector witnessed only a marginal decline (16.1 per cent as on January 2013) during the comparable period.

Inflation, household savings

The arguments in favour of easy monetary policy to support economic growth, without due emphasis on price stability, appear to have ignored the adverse impact of high inflation on domestic savings, which drives investment and overall economic activity.

It has been well-documented that acceleration of economic growth in India over the years has been largely associated with a similar acceleration in domestic investment, predominantly financed by domestic savings.

During the post-reform period, financial sector reforms, coupled with liberalised direct tax regime, facilitated significant growth in household financial savings and corporate savings.

Household savings, in particular, have been the main driver of domestic savings in India.

Within the household savings, while household financial savings enhances the productive capacity of the economy; household physical savings in the form of construction of house and purchase of gold, may not be as productive.

High inflation discourages household financial savings with falling and sometimes negative real return. On the contrary, it makes savings in physical form, like purchase of gold and other precious metals, very attractive.

There has been a growing concern over surging volumes of gold imports to hedge against inflation. This has also been corroborated by available data.

As shown in Chart 2, the share of physical savings in the total household savings has been positively associated with inflation, while the share of financial savings has been inversely related to inflation.

High inflation years are associated with falling shares of financial savings, and this has an undesirable effect on investment and economic expansion.

There are concerns on the serious adverse impact of high inflation on the balance of payments. It is widely believed that inflation makes imports cheaper and renders exports more costly, with implications on trade deficit.

As the current account deficit for India has been already high — around 4 per cent of GDP (and now above 5 per cent) in last couple of years — high inflation can make matters worse.

Moreover, many leading policy makers in India, notably among them C. Rangarajan, have discussed the implications for the poor and have strongly advocated ‘inflation control’ as an effective anti-poverty policy.

The recent slowdown in inflation is encouraging but the time may not be ripe to press the growth accelerator. Surely, the RBI without any pressure from North Block and the industry lobby will do a better job.

(The author is Reader, Department of Economics, Puducherry University.)

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