Monetary, fiscal and supply-side policies need to tackle price rise in tandem.
Inflation has raged unabated for the past five years — it started to decline earlier this year but picked up again in March. While there are many unanswered questions, it is clear that a simplistic inflation-targeting approach — a euphemism for stabilisation first and growth later — which is favoured by the IMF, has failed and will not work in India. We need a more comprehensive approach that will revive growth and lower inflation simultaneously.
As in most emerging markets, India’s growth rate has also declined. However, since 2010-11, India’s decline in growth has been twice the emerging market average. So, about half the decline in our GDP growth rate is attributable to factors unique to India.
But given the low rate of world inflation, India’s price rise remains a puzzle. When India was a closed economy, its inflation was higher than the world’s when shocks to the economy were largely domestic. And lower, when shocks, such as the oil price spike of the 1970s, were external. But today, with a largely open economy and capital account, it is hard to understand the persistent high inflation, especially when, in contrast, the world has been worried about deflation. There are three broad explanations for this.
First, India recovered quickly from the 2008 global crisis because of large fiscal and monetary stimuli. But these were maintained for too long and fuelled inflation. With a mostly open capital account, foreign inflows increased sharply, the real exchange rate appreciated and the current account deficit widened to dangerous levels. A consumption boom followed, and wages and the prices of land and services went up sharply. The RBI started tightening monetary policy in late 2011. But by then, it was too little, too late. The economy was also slowing down and the aggressive tightening had to be tempered to avoid hurting growth further. But core inflation still rose, and some argued that a more aggressive monetary stance was needed to break high inflation expectations.
But the loose fiscal policy continued in spite of the monetary tightening. Moreover, the composition of government expenditure tilted away from investment towards public consumption, due to the sharp increase in subsidies. Programmes like MGNREGA channelled money into the hands of the poor, and caused rural real wages to increase. Consequently, the demand for and prices of food both increased. This in turn caused wages to rise. A wage-food price spiral fuelled inflation further. Similarly, as incomes of the non-poor rose, their consumption shifted from grains to proteins, oilseeds and vegetables, whose prices rose sharply. With high government expenditure and the announcement of a new pay commission, the prospect of a wage-price spiral has already set in.
Third, internationally, as land-use shifted away from food grain to biofuel and feed production, international real food prices rose. This was transmitted into India via the increases in minimum support prices, which have now caught up with international prices. As grain MSPs were increased, production went up and the Food Corporation of India’s stocks increased to record levels — this also increased market prices sharply.
Now that MSPs have caught up with international prices, future increases should be moderate, which will help temper inflation. But this doesn’t explain the rapid price rise in other food items — vegetables, eggs, meat, milk, pulses and oilseeds. One wonders why their price elasticity of supply is so low. It is possible that the high MSPs and market prices for grains make them profitable and reduce the incentives to shift to the production of riskier vegetable and other commodities. Also, as the fixed costs of shifting production are high, it isn’t easy to increase the supply of these commodities in the short run. Or, it could be that without better retail chains, the higher prices are mostly captured by intermediaries and do not reach the farmer.
With high inflation persisting and the looming threat of drought, monetary, fiscal and administered price policy are all important. It’s hard to disentangle their effects. It is unlikely that inflation will quickly come down once MSP increases are moderated because core consumer price index inflation is stuck above 8 per cent. With some budget payments indexed to inflation — MGNREGA, for example — controlling public consumption will not be easy. The fiscal cuts have largely been in public investment. This crowds out private investment and hurts growth. Attempting to break inflation expectations will now require prohibitively high interest rates, which will increase the government’s own interest bill and hurt growth further. Added to this, a drought threatens to further energise food inflation.
The incoming government will need to employ a package of measures that will reduce inflation and revive growth.Fighting inflation first through stabilisation and worrying about growth later is an IMF approach that has not worked well elsewhere in the world. We cannot inflict such failed policies on ourselves. The interactions between monetary, fiscal and supply-side policies will need to be taken into consideration to get out of our current stagflationary predicament. A simplistic approach will not work.
The writer is director general, Independent Evaluation Office. Views are personal.