Monday, Sep 22, 2014

How not to fight inflation

Supply constraints are a result of poor administrative decisions. The argument that India’s long-term growth potential has been reduced from its historic highs cannot hold. Supply constraints are a result of poor administrative decisions. The argument that India’s long-term growth potential has been reduced from its historic highs cannot hold.
Written by Ajay Chhibber | Posted: February 18, 2014 12:44 am | Updated: February 18, 2014 10:03 am

Ajay Chhibber

Monetary tightening will only hurt growth. There are fiscal, administrative fixes.

The decline in CPI inflation to under 10 per cent in January is a welcome development but has little to do with monetary policy. It comes on the back of lower demand, sharply reduced government expenditure and lower food inflation, and is largely unrelated to interest rates. It also shows that inflation can be brought down much faster than the Urjit Patel committee report suggests. In India today, any policy that targets inflation through higher interest rates is not very wise.

The RBI is right to move towards using the CPI as the measure of inflation. The ambiguity in the RBI’s choice of index — the CPI or WPI — could be maintained as long as the two broadly moved in the same range, especially given the wide gulf in our understanding of the transmission of monetary policy. But once the two indexes started deviating from each other, which has been happening since 2009, this muddle could not be maintained.

CPI inflation remains high largely because of food inflation, which can be addressed through administrative action and supply-side solutions. Cereal inflation can be contained by releasing some grain stocks, which are well above the quantity we need to maintain as strategic reserves, into the open market and by changing the open-ended grain purchase policy with its rising minimum support prices to one of limited procurement to meet the needs of the PDS.

For other food items — vegetables, pulses, oilseeds etc — part of the solution lies in reducing marketing margins and handling wastage, in more nimble international trade and increasing supply. The funding needed for preparing land for cultivation is a major constraint in increasing supply. Most small farmers don’t have the financial capacity to make the shift, and so persist with grain production. This year, for the first time, small SC/ ST farmers have been allowed to use MGNREGA funds for one-time land development. Thanks to this, many small farmers will shift to more lucrative vegetable production, especially those who live near cities where they can market their produce more easily.

The other major reason for inflation is the level and composition of government expenditure — Central and state — which leads to high fiscal deficits. The Centre is trying very hard to contain its fiscal deficit. But even if it hits its target of 4.8 per cent of the GDP, the combined fiscal deficit of the Centre and states will still be over 7 per cent — among the highest in the world. The composition of government spending, from investment to consumption, has fuelled inflation as it has led continued…

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