Money for nothing

There is enough evidence of thrust to the inflation from the cost side. The prices of factor inputs like oil and basic metals and minerals have risen sharply over the last few months. On top of that, the rupee has depreciated by almost 5 per cent against the dollar in the last four months, contributing to inflation by raising the cost of imported inputs. The lack of pricing power is further reinforced in the auto sector, where manufacturers have not been able to pass on the rise in the price of steel to consumers.

Another cause of inflationary trends in the past has been the supply shock from agriculture. During the drought of 1979-80 and 1987-88, inflation touched 17.1 and 8.1 per cent, respectively. However, despite a drought in 2002-03, overall inflation stayed at a benign 3.4 per cent. This has been made possible by buffer stocks of rice and wheat, which help keep a lid on prices. Although prices of coarse cereals and oilseeds shot through the roof, they did not contribute much to overall inflation due to their low weight in WPI. Even though the performance of kharif crops is not expected to be too good this year, the price impact will be limited to coarse cereals, etc, which anyway have a low weight in WPI and cannot raise overall inflation significantly. Thus, one can safely conclude that cost-push factors dominate the current inflationary spurt.

The April credit policy had hinted that the soft interest bias may not be tenable. The bond market has already reacted to the rise in inflation and this is likely to manifest itself in a general rise in interest rates if inflationary pressures hold.

Rising inflation not only hurts consumers but also cuts into the margins of companies and therefore has a potential to choke industrial activity. Thus, government intervention is required to check inflation. The government recently announced that it will resort to fiscal and monetary measures to control inflation. While fiscal measures would involve a cut in duties, monetary measures would imply hardening of interest rates. Our prognosis of drivers of inflation shows that the current inflation is primarily a case of cost-push inflation. In such a situation efficacy of monetary measures becomes suspect. Monetary measures are more effective when the economy is overheated and monetary tightening, by reducing aggregate demand, puts a rein on inflation. It can be of little use in controlling the current round of cost-push inflation, most of which anyway is predominantly “imported”. Monetary tightening will put further pressure on interest rates and does not augur well for the recent up-tick in the investment cycle.

This leaves one with the obvious choice of fiscal measures. Reduction in customs and excise duties on commodities witnessing sharp inflation will lower the cost of production and bring overall prices under control. But the flip side of fiscal measures is a reduction in tax collections. Although the higher value of imports or the base on which taxes are collected will partially offset the impact of reduced rates, its overall impact will be lower tax collections. There is no free lunch. Given the over-optimistic tax targets in this year’s budget, this will put further pressure on deficits. Also, the effectiveness of duty reduction will depend on what happens to international crude prices. If their upward journey continues, even duty reductions may fail to check inflation.

As inflation rates are computed year-on-year one statistical factor driving the current inflation is the previous year’s inflation rate. This is known as the “base effect”. As inflation rates had started rising from September of last year, the base effect will bring inflation down from September this year. If fuel prices do not rise further and duties are reduced, we will see inflation rates dropping from September. Despite this the average inflation for the current fiscal is likely to settle around 6 per cent, and not 5 per cent as the government had expected.

(The writer is a senior economist with Crisil Centre of Economic Research. These are his personal views)