The RBI has held that it examines two macro-economic parameters closely before deciding on its policy action. These two parameters are the index of industrial production (IIP) as a marker of output patterns and the wholesale price index as a marker of price patterns. The standard practice is to look at the Y-o-Y (year-on-year) growth rates of IIP and WPI.

While the Y-o-Y growth in WPI, popularly known as the inflation rate, has been in the region of 9.5 per cent since the beginning of 2011, we have seen a lot of volatility in IIP growth in the past one year. Therefore, to get a sense of output and price patterns in the economy and the nature of monetary policy response, it is better to look at the relative movement of WPI and IIP during a longer time period.

We choose 2005 as the starting point, as it is the base year for the currently-used IIP and WPI. Instead of looking at y-o-y growth rates, if we consider the movement of indices, we find that the indices for WPI and IIP have moved up to 155.8 and 163.2, respectively, in September 2011, from a base of 100 in 2004-05.

This turns out to be per month growth of 0.59 per cent for IIP and 0.54 per cent for WPI. The output index has moved up faster than the price index; then, how is it that inflation is ruling at around 10 per cent and industrial output growth is struggling at around 5 per cent? The current situation is better understood if we analyse the growth in output and price indices across interest rate cycles.

In the previous tightening cycle during October 2005-October 2008, the index of industrial production (1.15 per cent) grew at a faster pace than WPI (0.5 per cent). In contrast, in the current phase of tightening between March 2010 and September 2011, WPI (0.77 per cent) has grown at a faster pace than industrial production (0.47 per cent).

If we consider the phase during which there was a policy lull for almost a year, or between April 2009 and March 2010, WPI grew by a CAGR of 0.82 per cent and IIP by 1.64 per cent.

THE POST-LEHMAN MOOD

What explains the behaviour of IIP and WPI in the different time periods? Following the collapse of Lehman, a combination of loose monetary and fiscal policy was pursued to ease pressure off the financial markets and limit the adverse impact of the contagion on the Indian economy.

The central bank took a number of conventional and unconventional measures to ease liquidity. These included augmenting domestic and foreign exchange liquidity and a sharp reduction in the policy rates. The RBI eased policy rates and brought down the repo rate from 9 per cent to 4.75 per cent in a short span of seven months, from October 2008 to April 2009.

Monetary policy measures were complemented by a fiscal stimulus package in 2008-09 in the form of tax reductions, investment in infrastructure and increased expenditure on government consumption to support aggregate demand. Notwithstanding the loose monetary and fiscal policy, the fears of a global recession led to a fall in both industrial production and WPI. The fall in prices (-0.54 per cent) during this period was much higher than the fall in output (-0.06 per cent).

The tentativeness of the global recovery prompted the RBI to continue with its easy money stance for the next 11 months. The RBI reversed course only in March 2010. Policy inaction for almost a year helped in building up of inflationary momentum.

WAGE-PRICE SPIRAL

Further, the Government went for another fiscal stimulus in January 2011, when wages under MNREGA were indexed to the consumer price index. The move was meant to protect the interests of the poor in a rising price scenario. However, when employment generated under MNREGA does not add to agricultural productivity and production, wage indexation will render the problem of inflation more acute.

Seen purely from an inflation management perspective, the indexation of MNREGA wages, without a corresponding increase in productivity, creates a wage-price spiral in the Indian economy. While the effects of cumulative rate increases have started to show their impact through a deceleration in IIP growth, the linking of MNREGA wages to inflation has led to a steep growth in the WPI between March 2010 and September 2011. As the government-decided wages under MNREGA act as a benchmark for wage fixation in other sectors of the economy, the indexation of MNREGA wages has wider implications.

The high inflationary expectations of households, despite the RBI effecting 13 rounds of rate increases since March 2010, is perhaps a reflection of the built-in wage price spiral in the system.

Policymakers, both monetary and fiscal, must take cognisance of this built-in wage price spiral. While the government can place a check on further fiscal policy-induced drivers of inflation, such as price subsidies, and higher minimum support prices, monetary policy needs to adopt a hawkish stance to dampen inflationary expectations, rather than actually raise rates any further.

The present battle against inflation can be won only if the government and the RBI live up to their responsibilities. In the final analysis, unless productivity in the system improves, inflation will continue to be a problem.

(The author is Associate Professor, avier Institute of Management, Bhubaneswar. The views are personal.)

Related Topics