The RBI's unexpected 50 basis-point hike in repo rate to 8 per cent shocked the markets. But, then, the central bank may not have had any other option to counter inflation; the 10 rate hikes till June and two bumper crops have done little to curb prices. From an inflationary situation that was driven primarily by food prices, we now have a situation of a more broad-based inflation, as acknowledged by the RBI itself.
Even as the inflation worry raged across Asia , most countries in the region, barring India, have managed to curb pricing pressures reasonably well. So what has led to this persistent pressure in India that has pushed the RBI to a more aggressive monetary policy mode? And would this put an end to the rallying prices? Sadly, there are reasons to believe that the inflation scare may not fade any time soon.
Too long for comfort
Let us first look at the length and magnitude of the inflation problem. While the average inflation was 5.5 per cent between 2006 and 2009, we have now had a whopping 19 months of over 6 per cent growth in the Wholesale Price Index (WPI) on a year-on-year basis.
Seventeen of these months saw inflation in the 9-10 per cent range. Clearly, the time period over which the current high level of inflation has lasted is above normal and a little disconcerting.
Moving to the constituents of the WPI basket, primary products (of which food accounts for a good 70 per cent) index has been expanding in double-digits for 22 months now. While the drought in 2009 was believed to have driven grain and fodder prices to steep levels, that primary products inflation never returned to single-digit, post the bumper summer and winter crops in 2010, does little to explain the still-elevated levels of primary article prices.
Contrary to belief that the recent administered price hikes in fuel would aggravate inflation, this index has been on a high for quite a while. The fuel index, has been on a double-digit trajectory for 17 months now, far ahead of the average of 4 per cent between 2006 and 2009. The last, but most important component of the basket, manufactured products, may have been slow to register an increase, but their effect appears to be the most lethal of them all. With a 65 per cent weight in the WPI, a rise of a couple of percentage points in this index can cause damage. To understand the impact that manufactured non-food products (called core inflation) can have on the headline numbers, consider the following:
Way back in January 2010, headline inflation was 8.7 per cent, when food inflation was a frightening 19.8 per cent and core inflation at a sedate 3.7 per cent. Now, with the food inflation down to 8.3 per cent; core inflation, at 7.3 per cent, has been the key trigger to push headline numbers higher to 9.4 per cent.
Why core inflation matters
The accompanying chart indicates that the WPI surge between December 2010 and June 2011 has been steeper than earlier periods as a result of core inflation contributing more to the inflation pie. While food and fuel inflation are known to be volatile it was the core inflation numbers that kept headline inflation under check or reined it back to comfortable levels on earlier occasions.
This was also made possible by the surge in investment as a proportion of GDP up to 2007-08. The supply from added capacities kept prices of manufactured products under check.
However, this time around, the RBI itself has expressed concerns over a soft patch in gross fixed capital formation (GFCF), visible from the second half of 2010-11. For instance, GFCF expanded by 19.2 per cent in the last quarter of FY-10 compared with a sluggish 0.4 per cent in the March 2011 quarter; this number being lower than any other March quarter since 2008.
Challenges ahead
Clearly, the spill-over effect of primary products inflation on manufactured goods, accentuated by lack of investment in the manufacturing space has pushed inflation to levels not easily reversible. The above sticky phenomenon of inflation clearly suggests that the RBI's baby steps of 25 basis point rate hike eight times between March 2010 and March 2011 did not help much.
With a steep 50 basis points in May 2011, on realising that demand-pull issues were fuelling inflation more than was anticipated, followed by another 50 basis point hike now, will the RBI be successful in curbing the more raging issue of demand? Easier said than done for the following reasons:
A moderation in manufactured non-food product inflation would be possible only if there is a softening of input costs and easing of demand. Let us take the first case. While commodity prices have shown signs of easing, fuel, a key input in most industries, would only now kick-start its journey upward.
While the direct impact of the recent administered fuel price hike on the WPI is only 0.7 per cent, the indirect impact, through user industries, could be much higher. Two, while electricity price inflation has remained moderate, it may be only a matter of time before the price increases in coal and mineral oils are felt in electricity prices.
Three, while it has to be acknowledged that demand has moderated as seen in auto sales, industrial production and purchasing managers index (PMI), it needs to be kept in mind that surging exports and non-oil import growth may not slow enough, especially the former, given the tight capacity globally. Fiscal risks arising from mounting subsidies too pose a threat to investments, keeping interest at elevated levels.
If these are the challenges to curb demand, the food problem is no better. Even as a normal monsoon can be expected to soften food prices, the recent hike in minimum support prices (MSP) in some of the agri-commodities can set the index rolling northward again, as MSPs typically set the floor for market prices.
Shortage of labour and steep hike in labour costs may also offset the price benefits of an otherwise good bounty. Permanent solutions to the food problem lie in addressing issues such as poor irrigation facilities, low yields, lack of proper storage and transportation facilities. These gather importance, more than ever, with consumption gaining ground.