Inflation: The Major Area of Concern for

Macroeconomics Management
By Chirag Badaya
MMS (part1)
PTVA’s Institute of Management

In its mid-quarter monetary policy review released in September 2010, the

reserve bank of India (RBI) has admitted that inflation remains the dominant
concern in macroeconomics management. Similar views are expressed by the
RBI in July 2010 under its first quarter review of monetary policy 2010-11
wherein containing and anchoring inflationary expectations were considered
to be the dominant concerns of the emerging policy stance.

This growing concern of the monetary authority essentially emanates from the
fact that the rate of inflation in India continues to remain at unacceptably high
levels so much so that March to June 2010 even witnessed double digit
inflation rates. This is in sharp contrast to the desired annual rate of inflation of
the order of 4 to 4.5 per cent during the medium-term and 3 per cent per
annum in the long term as aspired by the monetary authority in the line with
long term growth requirements of the Indian economy.

It is widely acknowledge that when the inflation rate crosses all permissible
limits, the real rate of interest in the economy tend to be negative which in
turn has a dampening effect of the growth of bank deposits as savers looking
for higher returns divert their surplus funds towards unorganised credit
markets. Once this happens, financial repression is likely to set in as genuinely
productive investment activities typically experience a severe credit constraint
while socially unproductive activities get easy access to funds thereby
hampering the growth process of the economy. As banks in India, of late, have
already begun to experience such a deceleration in their deposit growth, it is
high time to put a check on rising price level before it assumes catastrophic
dimensions and eventually leads to financial repression and poses a major
obstacle to economic growth.

The price situation is particularly worrisome in the light of the fact that
inflationary tendencies have started gathering momentum when the Indian
economy has still not fully recovered from the impact of the global economic
slowdown arising out of the financial crisis in the advanced economies
popularly known as the U.S. sub-prime lending crisis. Evidently it is imperative
to ensure that any attempt at containing inflationary pressure in India should
not jeopardise or endanger the growth recovery of the economy. This is all the
more crucial in the face of a uncertain global environment that prevails in the
current scenario.

It is worth nothing that the headline inflation in India is calculated on the basis
of the Wholesale Price Index (WPI) and recently the government has released a
new series of the WPI changing the base year from 1993-94 to 2004-2005. This
new series was in fact employed for the first time in calculating the official rate
of headline inflation for the month of August 2010. The new series is a better
representative of overall commodity price inflation in as much as it significantly
improves on the scope and coverage of commodities and is more adapted to
the underlying economic structure in terms of the evolving consumption
patterns and price trends at disaggregated level.

According to the new series, there has no doubt been a moderation in the
annual headline inflation rate from 9.8 per cent in July 2010 to 8.5 per cent in
August 2010. This slight moderation notwithstanding, it must be realised that
the headline inflation of the order of 8.5 per cent is well above the upper
bound of the comfort zone since it is still significantly above the trend of 5.0 to
5.5 per cent as observed during the 2000s. It must further be pointed out that
as per the new series, the annual food price inflation during august 2010 was
of the order of 14 per cent, which was even higher on the basis of the old
series.

Apart from food the Indian economy is particularly vulnerable to supply shocks
on the front of energy as reflected by the sharp and persistent increase in fuel
prices. In this context this is worth noticing that while the supply shocks on the
front of food primarily emanates at the domestic level say on account of
drought or poor monsoon, the supply shocks pertaining to petroleum, oil and
lubricants essentially emerge at the international level.

Further, such supply shocks have typically been observed to be reinforced by

demand side pressures in worsening the inflationary scenario in the Indian
economy. For instance, an increase in money supply unaccompanied by a
commensurate increase in the productive capacity of the economy is
potentially inflationary as it is likely to enhance the purchasing power and
thereby effective demand in the economy without there being corresponding
increases in supply. Such episodes of demand-pull inflation were more
common during the pre-reform era prior to 1990s wherein there was frequent
monetisation of public debt. In recent years, however, due to government’s
commitment to fiscal deficits under the regime of fiscal prudence and fiscal
responsibility legislations, the potential significance of this factor in
contributing towards inflationary prise rise in the economy has gone down.
The fact of the matter is that in the present context, even the government of
India has to carry out realistic cost-benefits has no option but to raise
resources from the market.

This should not, however, be taken to imply that demand-side factors have not
contributed towards the recently observed high inflation rates in India. For,
demand-side forces could operate in various forms at various levels. One such
instance is visible in the case of recent food inflation in India which is
essentially propelled by enormous increase in the demand for the various food
items beyond cereals such as protein-rich sources like pulses, milk, meat, fish
and eggs that are relatively deficient in supply. As the demand for sugar, fruits
and vegetables in the economy is surging and as increasingly affluent
consumers in India are gradually diversifying their dietary patterns away from
cereals and towards protein sources whose supply is unable to efficiently cope
up with the expansion in demand, the inevitable outcome is an increase in
prices. This evidently calls for immediate efforts to quickly increase the
availability of these items, as long-term outlook for food price inflation is
contingent on them.
It may be realised that apart from enhancing domestic capacity, supply In
economy can also be expanded by effectively tapping global sources as has
actually been done in the case of white goods in India under a regime of
globalisation and trade liberalisation ever since the early 1990s.

It is thus clear from the foregoing discussion that in the contemporary context,
sustaining the growth recovery while reining in inflation has become the top
priority area for macroeconomic management by planner and policy makers in
India. Towards this end, economic and public policy should be so designed as
to effectively tackle both the demand as well as supply driven inflation shocks
that are frequently experienced by the Indian economy.