Wednesday, April 2, 2008

Inflation: through the roof – way forward?

Inflation in India (WPI based) has already risen through the virtual roof (RBI’s comfort zone of 5 per cent) and is still going strong, largely because of higher food, metal and energy prices. This is creating strong supply side (cost-push) inflationary pressure on the economy with significant threats to growth in short term. Inflation has spurted in three weeks to a 14-month high of 6.68% on 15 March. It was 5.11% on 1 March and 5.92% on 8 March. The current fiscal measures announced by the government may help in curtailing the inflationary expectations however the WPI figures for next few weeks may still be ranging between 7-7.5 percent.

We are back to the bad old times of high interest rates and high inflation, which hit the common people (read “voters”) the most. Elections are due in next year and “voters” well known for their abrasive punishment to the governments in under delivering on price front and moreover with high interest rates.

The government has already used a series of import duty cuts to boost domestic supplies with a promise of more cuts to follow and has also resorted to banning exports. In the short run, the benefits of price controls in curbing inflation expectations may outweigh the detrimental effects. As inflation is mostly driven by food, as a result of supply shocks, rather than caused by excess aggregate demand. In the longer run, however, the damaging effects of price controls on incentives and efficiency will outweigh the benefits.

Under current situation, the monetary policy may very well look for a further appreciation of exchange rate, since bulk of this rise is coming from higher global commodity prices, without changing interest rates to make sure that aggregate demand conditions continue to be consistent with supply-side initiatives. Cost of appreciating rupee would be in form of reduced exports, without further widening the trade deficit though, due to high crude imports trading well above $100/barrel!

In medium term, interest rate reduction is imminent but only after the inflationary expectations cool-off, and good monsoon holds the key here. The important factor to note here is that the ban on food exports, low import tariff would eventually hurt Indian farmers, pushing them away from food grain production to cash crop productions. This could very easily bring India in the spiraling inflationary pressure!