Growth, inflation and monetary policy

The high level of inflation in the last two years has raised a question whether high growth necessarily demands high inflation. The issue of trade-off between growth and price stability is usually discussed in relation to the conduct of monetary policy.

A critical question that is debated in this context is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to sustain high growth. Empirical evidence on the relationship between growth and inflation in a cross-country framework is somewhat inconclusive because such studies included countries at one end with an inflation rate as low as 1 - 2 per cent and at the other end those with inflation rates going beyond 200 to 300 per cent.

Most of these studies, however, clearly establish that growth rates become increasingly weaker at higher rates of inflation. The well-known Phillip's curve postulated an inverse relationship between unemployment and wage rate. Several economists have challenged the basic micro-economic underpinning of the wage and price mechanism that leads to the possibility of trade-off between inflation and growth.

Price stability

The Phillip's curve becomes purely vertical, if the role of expectations is explicitly included. An environment of reasonable price stability is considered conducive to economic growth. Many would regard price stability as a necessary condition for long-run growth. This, however, does not rule out the possibility of some trade-off in the short-run.

The case of price stability as a major objective of economic policy rests on the assumption that volatility in prices creates uncertainties in decision making. Rising prices adversely affect savings while they make speculative investments more attractive.

These apart, there is a crucial social dimension, particularly in developing countries. Inflation adversely affects those who have no hedges against it and this includes all the poorer sections of the community.

This is, indeed, a very strong argument in favour of maintenance of price stability. We have had two years of high inflation. 2009-10 was badly affected because of the deficient monsoon. Food grain production declined by 17 million tonnes. The decline in the production of rice itself was 11 million tonnes.

High food prices

As a consequence, inflation was triggered by the increase in food grain prices. Food inflation stood at as high as 21 per cent in February 2011. Overall inflation as measured by the wholesale price index touched the peak of 10.9 per cent in April 2010.

It was expected that inflation would moderate through 2010-11. It in fact started happening till November 2010. However, prices started rising after that. As of March 2011, year-on-year inflation had touched 10.0 per cent.

While the food price inflation of 2009-10 was triggered by the rise in food grain prices, in 2010-11 it was triggered by the rise in the prices of vegetables, fruits and eggs, meat and fish. The increase in vegetable prices has been significant. The late rains had a severe impact on the supply of some vegetables, including onion. Inflation in vegetables rose to 34 per cent in December 2010 and 67 per cent in January 2011. Normally, vegetable prices show a seasonal decline during winter months. During 2010-11, prices of raw cotton rose on an average by 43 per cent. The persistence of food inflation led to the spread of inflation to other sectors. In 2010-11, the weighted contribution of the manufacturing sector to total inflation was 41.8 per cent.

Area of concern

Inflation continues to remain an area of concern in the current year. As of June 2011, the headline inflation in wholesale price index stood at 9.4 per cent. While inflation in food articles has eased from 10.6 per cent in April 2011 to 8.38 per cent in June 2011, inflation in manufactured products has risen from 5.3 per cent in January 2011 to 7.4 per cent in June 2011.

Weekly data show a further easing in food inflation in the second half of July 2011. However, primary food inflation still remains at a fairly high level and the possibility of a surge clearly exists, if the monsoon turns adverse. The rationalisation process in the pricing of petroleum products is still to be completed and this may have an impact on price levels in the coming months. Factoring all these, the headline WPI inflation would remain high till October 2011. One could expect significant easing in the last quarter of the year and inflation may come down to 6.5 per cent in March 2012.

Supply side constraints have to be necessarily eased in order to continue with growth along with price stability. However, interventions in the area of supply constraints take some time to mature, which only means that the problem has to be identified rapidly and the process of intervention rolled out with some haste.

In our case, at least as far as food grains is concerned, use of the official stocks in an imaginative manner can be used to keep prices under control as indeed has successfully been done in the last quarter of 2009-10.

Thus the extraordinarily high level of inflation seen in the last two years is due to certain severe supply constraints, particularly of agricultural products. The Table which gives the inflation rate and growth rate for the last six years clearly indicates that in the three years when the growth rate was around 9 per cent, inflation rate was not necessarily higher.

However, the fact that inflation is triggered primarily by supply side shocks does not mean that monetary policy has no role to play in such conditions.

As mentioned earlier, food price inflation, if it persists long enough, gets generalised. Thus, monetary policy and at one step removed, fiscal policy have to play their part in containing the overall demand pressures.

(Dr C. Rangarajan is Chairman, Economic Advisory Council to the Prime Minister).

COMMENT NOW