Ashima Goyal

Once more with anguish

Ashima Goyal | Updated on April 17, 2011

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Indian policy has many propagation mechanisms that convert a relative price rise into inflation. If policy-makers learn, from experience, to shut down such mechanisms, a low-inflation, high-growth scenario is possible.

With growth teetering and inflation high it is a good time to re-examine the relation between the two. Maintaining a reasonable rate of growth was a major success of Indian post-crisis macroeconomic policy. The inflation that accompanied it was not inevitable but a result of policy mistakes. In our historical experience, tight monetary policy reduced inflation, after supply shocks that normally triggered it, but at a high cost in terms of growth foregone.

This time, India was participating in the global coordinated monetary and fiscal stimulus. As oil prices collapsed after the crisis, inflationary pressure subsided sharply everywhere except in South Asia, where food inflation remained high. The impact of this sustained inflation on wages possibly explains the quick resurgence of WPI inflation in November 2009, when industry had barely recovered.

Tightening was delayed, given global uncertainties, and therefore protracted. It started only in the first quarter of 2010, and complementary policies required to forestall inflationary expectations were missing.

RELATIVE AND AGGREGATE PRICES

Food price inflation was dismissed as a relative price adjustment. But this neglected the large share of food in the average consumption basket, and the second round impact of sustained high food inflation on wages and prices. To argue relative prices cannot affect inflation assumes perfectly clearing markets and flexible prices and wages. Then a fall in one price balances a rise in another with no effect on the aggregate price level. But prices and wages rise more easily than they fall. So, a rise in one price raises wages and therefore other prices, generating inflation. Some relative prices, among them food prices and the exchange rate, have more of such an impact. Food prices are critical for inflation in India and, since international food inflation now influences the domestic, the exchange rate becomes relevant.

One reason the growth rate was the highest and inflation the lowest over 2003-07 was low global food prices — so, Indian food procurement prices (MSP) were not raised.

PROPAGATION MECHANISMS

Indian policy has a number of propagation mechanisms that convert a relative price rise into inflation. Procurement prices are one of these. World commodity prices rise and fall sharply. In India they do not rise as sharply, but also they never fall — an upward bias is imparted.

In 2007 as the gap between domestic and international food-grain prices rose sharply, farmers' lobbying secured steep rises over the next few years in the typical Indian pass-through of an international price shock. A second important propagation mechanism had also come into play. India's large rural population keeps wages at subsistence. But MGNREGA raised subsistence wages above productivity. States competed with each other in raising minimum wages since the Centre was footing the bill. Given an exit option, workers' could extract large jumps in wages.

For the first time, minimum wages were actually implemented. This is a good thing. But the demand for all types of agricultural produce rose, and productivity did not rise in step. MGNREGA's record in creating assets is poor as is that of infrastructure improvements. Moreover, supply chain inefficiencies meant prices consumers were paying were not reaching farmers and motivating a supply response.

EXCHANGE RATES

A higher real wage requires a more appreciated real exchange rate. This can be achieved either through a nominal appreciation or a painful and prolonged rise in domestic wages and prices. India's exchange rate policy selected the second and became the third propagation mechanism.

Sri Lanka and Bangladesh avoided too much exchange rate depreciation during the global crisis. They were the only South Asian countries whose CPI inflation dropped to low single digits by 2009 (see Charts). The strategic use of exchange rate in anti-inflation policy works. Since it affects the political economy of food prices and wages, its contribution to inflation is broader than just goods or commodity price pass-through.

After the depreciation immediately following the crisis peak in 2008, the Government decided to let inflows determine the exchange rate. Since 2009, intervention in the FX markets stopped. Inflows resumed soon, leading to appreciation. But at strategic periods, when inflation showed signs of softening, there were outflows, and depreciation prevented the softening of inflation. Expectations of high inflation firmed up.

The nation chose to hoard reserves rather than use them to prevent depreciation. This belongs to a fourth set of propagation mechanisms. Many policies give short-term benefits but raise hidden or indirect costs, thus contributing to cost-push inflation.

We did not get it right this time, and will have to go through a period of falling growth before sticky inflation expectations moderate. But if policy-makers learn from this experience and close down the propagation mechanisms it is entirely possible to have low inflation and high growth in the future. Rising productivity, especially in agriculture, can enable a non-inflationary rise in wages.

(The author is Professor of Economics. IGIDR, Mumbai. >blfeedback@thehindu.co.in)

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Published on April 14, 2011
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