Puzzle of high CPI inflationhttps://indianexpress.com/article/opinion/columns/puzzle-of-high-cpi-inflation/

Puzzle of high CPI inflation

Only one factor — rise in minimum support prices for foodgrains — explains most of the sustained high inflation.

Only one factor — rise in minimum support prices for foodgrains — explains most of the sustained high inflation.

There is something strange going on with India’s macroeconomy,especially with inflation. Zyfin’s latest inflation estimates for the GDP deflator for the period October 2012-September 2013 is at a 6.7 per cent rate. GDP growth for the same period is expected to be low at 4.7 per cent. CPI inflation,the new preferred measure of inflation at the RBI,was above 10 per cent in October. There are frightening stories about vegetable inflation,onion inflation,etc,being upwards of 50 per cent. Depressing growth and escalating inflation — what is going on?

The most common explanation (more in the nature of an excuse) for high inflation in India is to take recourse in the high international inflation in 2008 and the subsequent expansion of deficits around the world. But that was a one-year explanation for inflation in the developing world — except India! (see table). Indian CPI inflation has ranged between 8.4 and 12.4 per cent for the last six years. It is not as if this high inflation has gone unnoticed by the experts or the RBI. Each year there has been a new explanation for this persistence of inflation. Some of the popular candidates: high fiscal deficits,excess demand (then why is growth so low?),pricing power of Indian corporations (then why is non-food inflation contained?),the emerging middle class eating protein-rich food (then why did cereal prices go up so much?),and rupee depreciation (shouldn’t the cause be the other way?).

Then,there have been explanations as to why inflation should be going down. In case you have forgotten,there is the claim that food output will grow strongly and be at record highs this year. In the last three months,the rupee has appreciated by more than 10 per cent,but CPI inflation has not declined — in fact,it has gone higher. And of course there has been the 400-odd basis point increase in repo rates by the RBI,yet each year,and after each increase,CPI inflation has edged higher,and from a high base.

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It is true that some food price increases (for example,onions) have defied the weather or economic logic,but the entire food chain doing so is stretching both logic and imagination. How does one reconcile record food output with literally spiraling inflation of food? The Congress does it by stating that its policies have engineered growth in rural areas,and inclusive growth at that.

If incomes in the rural sector are booming,then incomes in the richer sector must be collapsing to yield GDP growth of only 4.7 per cent. And this number is put in perspective by noting that the last three years of per capita GDP growth in India is lower by a magnitude than in the last 20 years — and at 3.3 per cent per year,less than half the per capita growth that prevailed during the boom years leading up to the 2009 election.

So what is happening? The logic of Indian inflation is relatively simple and has been outlined in these columns many times before and was documented in detail in July 2011 in “Indian Inflation — Populism,Politics and Procurement prices”,available at http://www.oxusinvestments.com. The table updates these data to 2013.

What happens when the government raises the minimum support price (MSP) of foodgrains,especially that of rice and wheat,two crops that account for almost half the value of all the crops for which the government sets the MSP? When the government raises the MSP,the prices of factors of production involved in the production of MSP products — land and labour — also go up. Is it any surprise that rural wages have gone up so fast as to cause labour shortages in an economy with relatively jobless growth for the last nine years? For the last six years,rural wages have gone up by an average of 16 per cent. We don’t have reliable data on rural land values,but anecdotal data suggest that the price of this factor of production has also been rising faster than most prices in the economy.

So does this not increase the chances of the Congress getting elected in the rural areas? This is mostly why the Congress-led UPA did it — increase rural incomes,where the votes are. However,given the state election results of the last few years,this strategy seems to have backfired. One important reason: a dominantly large share of the expenditure of the poor is on food,and food prices have risen much faster than the average CPI increase of 10 per cent,resulting in a real wage increase of less than 3 per cent per year at best.

The UPA answer to high procurement prices in the run-up to the 2009 election was that these prices were being increased because international prices of food were going up. As,indeed,they were — world food prices (FAO data) increased at an average compounded rate of 6.7 per cent per annum between 2004 and 2009; UPA procurement prices increased at an average rate of 9.9 per cent. Since 2009,in the last four years,international prices of food have risen 7.3 per cent; UPA 2 price increase per year — 9.3 per cent.

The link between procurement prices and CPI is very strong theoretically and empirically. The table reports the results of a model that relates CPI increase to only one variable,the one-year lagged growth in procurement prices. The model is very parsimonious; no fuel prices here,no rupee value,no fiscal deficit,no money supply,no repo rate,no RBI,no purchase of gold and no current account deficit. Yet this model explains Indian inflation very well. For each 10 per cent rise in previous years’ procurement prices,there is a predicted 3.3 per cent increase in the current year CPI. In other words,if there was a zero rise in procurement prices last year,on an average,this year’s CPI inflation would be 4.6 per cent. The estimation is for the period 1978-2007,so all of UPA 2 data are out of sample.

Particularly galling and adventurous and destructive was the UPA-administered procurement price increase of 11.5 per cent in 2011 and 16.2 per cent increase in 2012. In 2012,the price of rice was increased by 16 per cent,coarse cereals by 20 per cent,sugar by 17 per cent and wheat by 5 per cent. The model predicted a 10 per cent increase in CPI in 2013 — the actual result — 10 percent! The average forecasting error for the out of sample six years — only 1 per cent per year.

Six-year CPI inflation in 2008-13 has been the highest since 1950; 10 per cent per annum matching the 10.1 per cent rate achieved in the six years ending in 1975. For the six years ending in 2012,the MSP increase has also been the highest: average of 12.5 per cent per annum. A lag of one year as per the model. The UPA will say coincidence,I will say rank stupid populist policy which did not help rural India (except land owning farmers),lost them state elections and has lowered GDP growth far below potential,and below anyone’s imagination.

The writer is chairman of Oxus Investments,an emerging market advisory firm,and a senior advisor to Zyfin,a leading financial information company.