The cost of misrepresenting the inflation
Globally, inflation is now the prime concern of governments, even as there is a speculation that a recession may not be far behind. In India, though, government agencies regularly announce that India is growing at a much faster rate than most economies and presently assert that inflation is much lower. The growth performance is not so surprising given that among the larger economies of the world, India’s economy contracted the most in 2020-21. But despite the sharp recovery, real output in 2021-22 was barely higher than in the pre-pandemic year of 2019-20.
On the claim that inflation in India is not so high in an international comparison, note that before the recently announced rise in the U.S. inflation rate for June, inflation here was close to what it was there. While the data on inflation in India is in the public domain, the public may be excused for not seeing that India’s economic agencies appear to have not fully understood what is driving it, for this requires some specialist knowledge. The Governor of the Reserve Bank of India (RBI) has been reported as saying that there was a “need to recognise global factors in inflation” (The Economic Times, July 9). In our view, the diagnosis that the current inflation in India is, even largely, due to global factors is wrong, and harmful for reasons that we set out.
It is a commonly made mistake to observe sharply rising prices of certain goods and conclude therefrom that it is this that is driving the inflation. This conclusion can be way off the mark when the concerned goods account for only a small part of the consumption basket that the overall consumer price index is based on. Thus, while the price of edible oils and the world price of crude may have risen following the Ukraine war, the impact of this development on overall inflation in India, measured by the rise in the consumer price index, would depend upon their share in the consumption basket of households, which is relatively low. Our investigation of price trends among the major commodity groups threw up some findings crucial to understanding the current inflation in India. Contrary to the belief that the rise in inflation in India is due to higher international prices, we found that for the commodity groups ‘fuel and light’ and ‘fats and oils’, chosen as proxies for the price of imported fuel and edible oils, respectively, inflation has actually been lower in the first five months of 2022 than in the last five months of 2021. On the other hand, for the commodity group ‘food and beverages’, it was exactly the reverse, i.e., inflation has been much higher in the more recent period. Not surprisingly, the estimated direct contribution of this group to the current inflation dwarfs that of all other groups, establishing conclusively that the inflation is driven by domestic factors. This is also readily seen when we find inflation in India trending upwards from October 2021, that is, well before the war in Eastern Europe.
While the Governor of the Reserve Bank of India may have flagged global factors in the current inflation, its monetary policy seems to be based on a somewhat different view. Starting in May, the repo rate has been raised. Raising the interest rate in an attempt to control inflation, implicitly assumes that it reflects economy-wide excess demand. Such a diagnosis of the current inflation is belied by the fact that the price of food is rising faster than that of other goods i.e., its relative price has risen. So, the excess demand is in the market for foodstuffs, and it is this that needs to be eliminated. To persist with monetary policy to curb inflation under these circumstances is to miss the point that, being a macroeconomic instrument, it cannot affect any particular price.
The inadequacy of monetary policy to address food-price-driven inflation has been flagged by economists internationally. Thus, at the World Economic Forum’s annual meet held at Davos, Switzerland in June, Nobel Laureate Joseph Stiglitz observed that “Raising interest rates is not going to solve the problem of inflation. It is not going to create more food. What you do is that you have supply-side interventions. Killing the economy through raising interest rates is not going to solve the inflation in any time frame. We used to have surpluses in food in the United States — we can get those back. At least, trying to do everything we can globally to increase the supply is going to do more in dealing with the problem.” (The above passage is an arrangement of the speaker’s comments made to Bloomberg). Another observation comes from the head of the U.S. central bank itself, the Federal Reserve Bank, made to the U.S. House of Representatives in June. Jerome Powell is reported stating that even though the Fed's resolve to fight inflation is unconditional, "a big part of inflation won't be affected by our tools”. This is an acknowledgement that there is only so much a central bank can do when battling inflation driven by the rise in energy and food prices. That an independent economist would suggest the impotence of monetary policy to control food inflation is not news, but when the head of a leading central bank does so, it should draw our attention. Interestingly, those responsible for inflation management in India continue to give the impression that the current inflation can be dealt with effectively by monetary policy.
This stance by the economic arm of the government of India, that inflation can be controlled by monetary policy, could have been ignored were it not potentially harmful. To hold on to the view that inflation in India is due to excess aggregate demand curable by raising interest rates ensures that attention is not paid to the necessary supply-side interventions. Note the call by American economists to bring back the food surpluses in the U.S., even when their country has hardly ever experienced food shortages. By comparison, food in India has never been plentiful, reflected in the high share of the average household budget devoted to it. And, there is here an undercurrent of a food price inflation, which, by exacerbating poverty, stands in the way of a more rapid expansion of the economy.
As the current inflation represents a domestic imbalance, it will not end with the crashing of food prices taking place on the global market right now. The failure to see inflation in India as the reflection of a structural feature of its economy ensures that there is little chance that one of India’s urgent problems will be solved.