INFLATION IN INDIA AND ITS IMPACTS ON THE ECONOMY
Origin of Inflation
Initially, Inflation originated with the debasement of the currency meaning that gold coins were collected by the government i.e. usually the king or the ruler of the region melted down, mixed with other metals (often lead) and reissued them at the same nominal value. As a result the total nominal value of coins in circulation and the money supply in the economy increased. However, the "real value" of each unit of currency, i.e. gold coin decreased as it was no longer pure gold. This led to an increase in nominal prices, because of which a consumer had to pay more mixed coins in exchange for goods and services than they previously paid in terms of pure gold coins. By the 19th century, the word inflation started to appear as a mirror image to the action of increasing the amount of currency units by the central bank.
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In Classical Political economy, inflation simply meant increasing the money supply and deflation meant decreasing it. Economists from some schools of economic thought still follow it. Classical political economists from Hume to Ricardo distinguished between them and debated the cause and effect relationship: - for example the Bullionists argued that the Bank of England had over issued banknotes (increased the money supply) and caused 'the depreciation of banknotes'. That is it created inflation.
In today's world increase and decrease in the money supply mainly results from actions by central banks. The effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world. In contemporary economic terminology, these will be referred to as expansionary and contractionary monetary policies.
Mainstream economists believe that inflation is a measure of changes in the general price level. The difference is that Austrian economists claim that inflation is the result of producing more units of money, whereas the mainstream economists consider inflation as the effect rather than the cause. Maximum schools of economics agree that changes in the money supply relative to the level of economic activity affects the price levels, there is no direct relation with the quantity of money for example- changes in price levels are affected by the velocity of money, and inflation can occur with a substantial lag between the increase in the quantity of money and by the rise in the general price level.
What is inflation?
Inflation is generally defined as a process of persistent and appreciable rise in the general level of prices. In other words, it measures the annual rate of change of the general price level in the economy. Four important points to note about the definition is that-
Inflation is a sustained increase in the average price level and not a state of high prices. It is a state of disequilibrium between the aggregate demand and aggregate supply at the existing prices, necessitating a rise in the general price level.
Inflation refers to a situation of appreciable or considerable rise in prices.
Rise in prices should not only be appreciable but prolonged in order to be termed as inflationary price rise.
It is measured as the rate of increase in the price level as indicated by the price index.
When prices rise, the value of money falls. In other words, there exists an inverse relationship between the price level and the internal purchasing power of money. During inflation money buys less in real terms. To protect from the effects of inflation people can invest their money in the financial assets that give a rate of return at least equal to the rate of inflation. On the basis of rate of inflation we can distinguish between the following types of inflation-
Creeping Inflation- rise in prices over time at a mild rate, say around 2% to 3% per year.
Walking Inflation- rate of rise in inflation is of intermediate range of 3% to 6% per year.
Running Inflation-rise in prices is over 8% and around 10%. It normally shows two digits of inflation and acts as a warning signal indicating the need for controlling it.
Hyperinflation-when monthly increase in prices is 20% to 30% or more. At this stage, there is no limit to price rise, and price rise goes out of control. There is complete collapse of the currency and economic and political life is disrupted.
Open Inflation-in this prices are permitted to rise without being suppressed by government price controls or similar techniques.
Suppressed Inflation-when inflationary pressures exist in the economy, but prices are controlled by certain administrative measures such as rationing.
Deflation is a state of persistent and substantial fall in prices and increase in the purchasing power of money. It is caused by decrease in demand or increase in supply. Some countries such as Japan and China have experienced price deflation in their economies in recent years.
Stagflation it is the combined phenomenon of demand-pull and cost-push inflation. One of these situations is in the form of stagflation under which economic stagnation, in the form of a low rate of growth, combines with the rise in general price level.
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Reflation is an attempt to raise the general level of prices to counteract deflationary pressures.
What is Inflation Rate?
Inflation rate is a measure of inflation, which means the percentage rate of change of a price index, such as the Consumer Price Index (CPI) and the decrease in the purchasing power of money is approximately equal to this rate.
It is used to calculate the real interest rate, as well as increase in real wages, and official measurements of this rate act as input variables to COLA adjustments and Inflation derivatives prices.
Inflation rate is usually expressed in annualized terms, though the measurement periods are generally different from one year. Inflation rates are often given in seasonally adjusted terms, excluding systematic quarter-to-quarter variation.
Measures of inflation
Inflation is measured by the Wholesale Price Index (WPI) and Consumer Price Index (CPI). Inflation rate in India is measured by the wholesale price index (WPI).
Currently, WPI (Base year 1993-94 =100) is a combined index of 435 articles/items, comprising of 98 'primary articles', 19 items of 'fuel, power, light and lubricants' variety and 318 'manufactured products'. This index is widely used in India to measure inflation because of its availability on a weekly basis and also the absence of a representative retail price index at such regular high frequency.
Another common measure of inflation is the Retail Price Index.
WPI preferred to CPI because-
wider commodity coverage
available on weekly basis
computed at all-India basis
P0 - P-1
Inflation rate =___________ X 100%
P - 1
P0 is the current average price level and,
P âˆ’ 1 is the price level a year ago.
After the year the purchasing power of a unit of money is multiplied by a factor 1 / ( 1 + inflation rate/100).
Some other ways of defining the inflation rate are logP0 âˆ’ logP âˆ’ 1 (using the natural log), again stated as a percentage. Then in this case after a year the purchasing power of a unit of money is multiplied by a factor e âˆ’ inflation rate.
There are two general methods for calculating inflation rates - one is to use a base period and the other is to use "chained" measurements. Chained measurements adjust the prices as well as the contents of the market basket involved, with each price period. Most commonly used is the base period reference.
Inflationary trends in India
The Indian economy has shown a remarkable growth after the adoption of liberalization policy. The opening up of the Indian economy in the early 1990s led to increase in industrial output and simultaneously raised the Inflation Rate in India.
There was an immense pressure on the inflation rate due to the stupendous growth rate of employment and industrial output. The main concern of the Reserve Bank of India (the central bank) and the Ministry of Finance, Government of India was the prevalent and intermittent rise of the inflation rate. Increasing inflation rate could be detrimental to the projected growth of Indian economy. Thus, the Reserve Bank of India was putting checks and measures in various policies so as to put a stop to the rising inflation. The Indian business community and the general public were assured by the central bank that the inflationary rise was harmless but still certain apprehensions existed among them.
The pricing disparity of agricultural products between the producer and end-consumer was contributing to the increasing Inflation Rate. Apart from this the steep rise of prices of food products, manufacturing products, and necessities had also catapulted the Inflation Rate. As a result of all this, the Wholesale Prices Index (WPI) of India reached 6.1% and the Cash Reserve Ratio touched 5.5% on 6th January, 2007.
The Reserve Bank of India gave top priority to price stability in its recently drafted monetary policy so as to arrest the panic and discomfort amongst the Indian business circles. It also aims to sustain the stupendous rate of economic growth of India. The Reserve Bank of India raised the Cash Reserve Ratio and used it as a tool to arrest the increasing Inflation Rate.
Rationalizing the pricing disparity between the producer and the consumer is the only solution to this problem. Only this will ensure inflation stabilization and thus sustainable economic growth of India.
RECENT INFLATIONARY TRENDS
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With 9% expansion in FY2007 India completed its fifth successive year of sturdy growth, even against price escalation in almost all commodities and a backdrop of growing turmoil in international financial markets. There was a remarkable increase in the performance of agricultural production of 4.5% whereas industry and services growth were facing a downfall.
From the beginning of FY2008 the Indian economy faced a rise in the prices of vegetables, pulses and other basic food stuffs. All this was accompanied with sharp rise in the prices when the annual policy statement for 2008-09 was unveiled on April 29. Inflation increased steadily during the year, reaching 8.75% by the end of May and in June when this figure jumped to 11% then there was an alarming increase in the prices. There were many reasons for it but one of the main driving forces was reduction in government fuel subsidies, which lifted gasoline prices by an average 10%. Indeed, by July 2008, the key Indian Inflation Rate i.e. the Wholesale Price Index touched the mark of 12.6%, highest rate in past 16 years of the Indian history. This was almost three times the RBI's target of 4.1% and almost doubled as compared to last year. This continuous rise slipped back to 12.4% by mid-August.
Since the beginning of 2008 combination of various internal and external factors led to steep domestic inflation and the resultant steps taken to control it in were slowing the pace of expansion. These factors included the marked rise in the international prices of oil, food, and metals, moderating the rate of capital inflows, worsening current and fiscal account deficits, increasing cost of funds, minor depreciation of the Indian rupee against the dollar, and slow growth in industrial economies. The Indian economy was at a critical juncture where policies to contain inflation and ensure macroeconomic stabilization have taken center stage.
In the first quarter of FY2008 (i.e. April-June), growth rate of GDP slowed down to 7.9% from 9.2% in the corresponding prior-year quarter, for the slowest expansion in three and a half years. The most remarkable decline was in industry where growth rate fell to 6.9% this was mainly because of cutting in the manufacturing growth rate to 5.6%. The slowdown was widened when agriculture and services sector showed a negligible growth of 1.4% and 0.9% points, below their performances of the year-earlier quarter. Over the medium term, the main objective of the government was to bring down inflation to 3%. The Repo and Reverse Repo Rates remained unchanged whereas Cash Reserve Ratio (CRR) was increased by 0.25 percentage points. The increased CRR that was effective from May 24 was 8.25%. Just days before the policy statement, the CRR was again raised by 0.50 percentage point and over Rs. 27,000 crore of bank deposits was impounded in three stages.
Consumption expenditure showed a steady growth in the first quarter of FY2008. Expansion in fixed investment fell to 9.0% from 13.3% due to increasing interest rates and a weakening global and domestic outlook appear to be causing companies to cut down their investment. Data available for June confirms a general slowdown in the industrial production, which is most noticeable in basic, intermediate, and production of capital goods. This indicates that investment in the recent years has accounted for much of GDP growth; rising to about 34% of GDP in FY2007-is slackening. Consumer durable goods production increased due to strong rural demand whereas nondurable goods production contracted.
A survey of manufacturing companies was conducted by the Reserve Bank of India in June 2008 which indicated a moderation in business optimism. This was corroborated by the composite business optimism index for July-September 2008 that was prepared by Dun and Bradstreet, which shows a decline of 11.2% as compared to the previous quarter. In July, the BBB- rating on foreign currency debt was confirmed but downgraded the view for India's long-term local currency debt from stable to negative, with a noticeable deterioration in the fiscal position.
Liquidity management became the primary objective for the central government. RBI did not resort to increase the Repo Rate i.e. the rate at which it lends to the other banks against securities. The reason behind this was that during times like this when the liquidity is high, banks will not be borrowing from the RBI. Banks are supposed to decide on their interest rates when there is a CRR hike and consequent monetary tightening. All this generally lead to increased interest rates that are a desirable outcome in times of inflation.
Growth of the broad money supply (M3) had to be moderated in the range of 16.5 to 17 per cent. While deposits were scheduled to rise by 17% and non-food credit disbursements by banks will grow at a slow rate of 20% as compared to 22.5% in 2007-08. Credit disbursed by banks last year was less as compared to the previous period. Bank credit had grown by a scorching 30% every year for consecutively three years beginning in 2004-05.
Inflation based on the WPI gradually begun to rise from December 2007. It surged in the first 5 months of FY2008 to touch a 16-year high of 12.6% in early August but later on slipped back to 12.4% by mid-August. Hardening of prices of primary articles and manufactured products led to a remarkable increase in the prices. Food inflation increased by about 2% points in the first half of FY2008; thereby reaching a mark of 9.8% in mid-August.
Central government sought to limit price pressures by tightening monetary policy and adopting various ad hoc interventions which includes reduction in customs duties on certain basic food items, steel, crude oil, and oil products. Export of wheat, non-basmati rice, and pulses was banned and export duties on some steel products were imposed.
RBI has altered key policy instruments to control inflation pressures in FY2008. These alterations included raising the cash-reserve ratio several times and taking it to 9% by the end of August and increasing the Repo Rate to 9% by July 29. Whereas the Reverse Repo Rate (the rate at which banks park their surplus funds with RBI) remained unchanged i.e. 6%.
The prime lending rates maintained by the monetary policy were above 12% since January 2007 when inflation previously breached RBI's tolerance level, even though inflation subsequently subsided. By the end of August 2008, prime lending rates were in range of 12.75-13.25%whereas the lending rates for nonprime borrowers were in the range of 15-17%. All this could neither reduce credit expansion nor arrest the rise in prices. The root cause behind all this was that the real interest rates have fallen.
Credit to the commercial sector by the banks has been rising in FY2008 with year-on-year growth climbing to 26.8% by the end of July from 22.3% at end-March. The two main reasons for the ongoing credit expansion were- a) High demand for working capital by the state owned oil-marketing companies and b) bank loans to fill in for diminished foreign funding. Data on foreign borrowings for FY2008 are not available; the cost of credit default swaps on prime Indian companies is an indicator of risk aversion and tight access for maximum domestic companies.
Fuel prices were artificially low due to a limited pass-through of international prices to the domestic market. As a result it repressed inflation, fostered demand pressures and created off-budget liabilities. Special bonds were issued to compensate state-owned oil-marketing companies for selling less than their cost. This thereby resulted in "under recoveries" in FY2007 amounting to Rs212.5 billion, or 0.5% of GDP. However these bonds could cover only a part of the loss whereas the rest had to be absorbed by the companies. Domestic fuel prices were raised by about 10% when the average price of the Indian crude basket increased to $130 per barrel in June 2008. This step was taken to limit the fast-growing losses. No compensation was provided to the private oil-marketing companies for their losses stemming from price competition with the state companies and thereby leading to some closures in their marketing operations.
The combined budget deficits of the central and state governments have been substantially reduced over the past 5 years. This reflected sincere efforts by the government to adhere to fiscal responsibility legislation. For FY2008, the central Government's deficit is budgeted at 2.5% of GDP and the states' at 2.1% (4.6% of GDP on a consolidated basis). The major factors that strengthen the appreciable fiscal consolidation from the base were a wider tax base supported by a buoyant economy and improved compliance.
Two main situations that must be overcome before achieving the deficit targets for the FY2008 are: a slowing economy that may limit the revenue buoyancy seen in recent years and continuous pressure by the Central Government to raise the salaries of its employees by 21% (about 0.3% of GDP) in response to recommendations of the Sixth Central Pay Commission. Similar wage increases were announced immediately by half a dozen states and others were following the suit. On the other hand provision for these salary increases was not budgeted.
Expected magnitude of off-budget subsidy items is the major current fiscal issue which undermines fiscal consolidation. The Economic Outlook prepared by the Economic Advisory Council to the Prime Minister for the current year calculated three things-
That at a crude oil price of $130 per barrel, after considering the increase in price and apportioning some contribution from oil production companies. The Government would require issuing oil bonds to certain marketing companies of about Rs. 1.2 trillion or equivalent to 2.2% of GDP.
That bonds amounting to 1.2% of GDP (Rs645 billion) need to be issued because at prevailing import prices the budgeted fertilizer subsidy underestimated the cost.
Similarly calculation showed that the food subsidy requires a bond issue of 0.8% of GDP.
The bonds issued for oil-marketing companies, fertilizers and food corporations of 4.2% of GDP need to be sold so as to allow these companies to continue because their size is likely to create monetary pressures. Private bank credit expansion in FY2007 was around 10% of GDP which indicated problems for future. Thus, the addition to credit demand by issuing such large bond resulted in steep rise in interest rates, crowd out investment, and piling up of inflation pressures. All this continued unless the monetary policy was tightened sufficiently and the interest paid on the bonds also led to fiscal pressures.
The trade and current account deficits have shown a tremendous increase in recent years, due to escalating oil prices and the expansion in non-oil imports. This all was led by rapid growth in consumer and investment demand. In FY2007, merchandise export growth was 23.7% whereas the import growth was 29.9% and the resultant outcome was that the trade deficit widened to $90 billion (7.7% of GDP). The current account deficit was at $17.4 billion approximately 1.5% of GDP, by the country's healthy invisibles balance that stems mainly from exports by its successful software and business services industry.
Exports expanded rapidly by 24.6% whereas imports expanded at 34.2%. Total oil imported accounted for nearly 35% of total imports and increased by 54.9% to $35.0 billion. On the other hand non-oil imports rose by 25.2% to $65.4 billion but at a slower pace as compared to FY2007. This reflected decelerating economic activity in the first 4 months of FY2008.
Net foreign investment, including nearly $30 billion of portfolio investment as well as heavy commercial borrowing by Indian companies led to capital account surplus of $108 billion in FY2007. Foreign exchange reserves swelled to $300 billion at end-March 2008. Portfolio investment recorded net outflows during April-July 2008 whereas direct investment increased. Foreign exchange reserves have fallen by $13 billion in the first 5 months of FY2008 and as a result the net capital inflows are on an appreciably lower level than last year. This drop in the foreign reserves indicates that capital flows were insufficient to cover the current account deficit. The accumulated reserves acted as a cushion against external vulnerabilities.
In the first quarter of FY2007 Indian Rupee appreciated against US Dollar, and then remained stable for the rest of the fiscal year. Indian Rupee depreciated by 8.7% in the first half of FY2008. By the end of August the exchange rate was Rs43.79/$1 and this clearly reflected the toll of rising inflation, growing current account deficit and weakening capital inflows. Exporters were being benefitted by the depreciation of the Indian Rupee. An outflow of funds from the stock markets has been the key reason for the rupee erasing all its gains seen over the past five years. In real effective exchange rate terms, rupee appreciation of 2007 had been offset by the end of the first quarter of FY2008.
Commodity prices were rising but did not benefit the producers. The Government was facing a difficult situation with some sections of the economy complaining of rising commodity prices and leading to an inflationary situation. The terms of trade worsened for the farmers and they received low prices for their products.
Central government along with RBI adopted various measures to control prices during the last few months when the rising prices of necessary commodities became the topic of discussion inside and outside the Parliament. The measures adopted were both direct and indirect in nature. The indirect measures included resort to fiscal and monetary instruments.
In reality, if one person benefits, the other automatically looses. However, in this case no one was getting the benefit and no one was suffering any loss.
Solution to this problem lies in an efficient marketing system.
EFFECTS OF INFLATION
Inflationary pressures in any economy leads to depreciation of its domestic currency. This is what our Indian economy was facing due to the running inflation and as a result Indian rupee depreciated by about 20% since April 2008. Inflation affects-
Common man: Inflation effects a common man in different roles such -
As a consumer: Products such as crude oil, fertilizers, pharmaceutical products, ores and metals, or use imported components such as Personal Computers and laptops are directly imported. Due to depreciation of the Indian Rupee all these goods became very expensive.
Components in computers such as processor, hard disk drive and motherboard are also imported. Products such as mouse, keyboard and monitor also witnessed an impact on their prices due to Rupee depreciation. Inflation may rise in an economy when the input costs increase.
As a borrower: Companies or individuals, who have borrowed foreign currency such as students with loans for studying abroad, need to pay more at the time of repayment as the rupee depreciates. Many dollar-denominated loans resulted in FOREX losses for companies with dollar loans, because of increased interest payments and principal amount occasioned by the declining rupee.
For e.g. - if an individual borrows $100 when the exchange rate was Rs 45 for 1$, his original borrowing is Rs 4,500. After the rupee depreciates and new exchange rate is Rs 48 for 1$, then the same loan amounts to Rs 4,800. If the interest rate is 10 per cent, the additional interest turns out to be Rs 30 and an addition of 0.67 per dollar borrowed (30/45). Thus, the rupee depreciation results in an incremental outflow of $7.34 (6.67+0.67) for this borrower.
In the case of loans taken via the Foreign Currency Non-Resident - Banks (FCNR (B)) route, the borrower has to make sure that the overall cost of borrowing (cost of forward forex cover coupled with interest cost) in foreign currency is lower than the rupee cost of funds.
As an investor: Depreciation of rupee makes imports of various components, capital goods and raw materials more expensive. As inputs and other equipment that are imported get costlier and reducing the profit margins. Companies that import goods in bulk and those with heavy foreign currency borrowings may be marked down in the stock market as the rupee depreciates.
As a Wage-earner: during inflation this class of common man suffered a lot because of two reasons-
Increase in wages and salaries failed to keep pace with the rising prices.
Wages increased during inflation but there is always a time lag between the rise in price and increase in wages. As a result common man looses during the intervening period.
Export companies: Due to depreciation of domestic currency exporters receive better prices for their goods and services when sold in foreign markets.
Foreign Investors: Depreciation of Indian Rupee reduced the returns that foreign investors used to earn by investing in Indian companies. Depreciation of a currency triggered FII outflows. NRI investors, who previously invested their money in India under various deposit schemes due to high interest rates, started finding those schemes less attractive on account of rupee depreciation.
Country's Balance of Payments: One of the drawbacks of depreciation of Rupee is that exports become cheap in terms of foreign currency and imports become costlier. Current account deficit widened because Indian imports basically constitutes essentials such as crude oil, natural resources and many capital goods.
Depreciation of Indian Rupee made the exports more competitive globally and as a result higher exports covered up the trade deficit.
IT companies: The IT sector is amongst the highest recruiters in the Indian economy and a depreciating rupee spells good news for the sector. Bills for Information Technology companies are basically prepared in dollars or in other foreign currencies. Depreciation of the rupee increased their realizations and bodes well for their margins. The main reason for the good performance in the second quarter of Infosys Technologies and Satyam Computers was the depreciation of the Indian Rupee. An estimate suggests that a 1 per cent depreciation in the rupee expands an IT company's margins by 0.30-0.40 per cent.
Farmers: The prices of the primary commodities such as minerals, diesel oil and fuel, power light and lubricants went up significantly. This disparity affected the agricultural sector in two ways-
It had a restrictive effect on investments in farming and affected the production efficiency.
On one hand the agricultural commodity prices were falling or stagnant and on the other hand increasing prices of agriculture inputs and other daily life commodities led to deterioration in the living standard of the farmers.
Prices paid by the consumer have impacted by the cost of living of the entire value chain, which grows on the inefficient markets and this adds to the final cost of the material. For example, high energy cost itself has contributed to the increase in the cost of inputs required for agriculture besides pushing up the marketing costs of farm products.
Hierarchy of objectives
Previously monetary policy had to reconcile the needs of economic growth with price stability. According to the recent trends 'deft balancing acts' are less visible. Inflationary pressures in the short-term were so acute that the RBI has to not only adopt some policy but more importantly has to be seen doing something. The three stage CRR hike, with the biggest increase of 0.50 percentage point was declared ten days before RBI announced the annual policy. This clearly demonstrates what monetary policy can do in the circumstances. No repo rate hike acted as an overt signal for banks to raise rates. Whereas the RBI is implying that liquidity containment (through CRR) mark-ups are sufficient. In any case the main focus of recent policy statements has been distinctly on inflation. There is a hierarchy of policy objectives clearly laid down for this time:-
(a) Price stability and anchoring inflation expectations,
(b) Ensuring orderly conditions in the financial markets and
(c) Creating conditions that are conducive to the growth momentum.
Such prioritization is necessary at this juncture and is specifically for the short-term. Enormous turbulence in the financial markets abroad influenced to have stability in the domestic financial market. So far only the equity markets in India have been affected but evidently the threat of a contagion is real.
According to the RBI the factors that have guided its approach are:-
(a) Immediate challenge of high and volatile food and energy prices. They possibly contain some structural components suggesting that the food and energy prices may not come down appreciably.
(b) Demand pressures persist but there has been some improvement in the domestic supply side response along with a build up of capacities.
(c) Though operating with a lag, monetary measures undertaken since September 2004 continue to have a stabilizing influence on the economy.
(d) Along with domestic factors, international factors matter in deciding the policy for anchoring inflation expectations.
(e) While short-term considerations decide RBI's immediate responses, obviously it cannot ignore longer term goals.
In an interesting observation, the RBI says "it has to reckon with the potential for 'exaggerated bearishness' in the Indian context".
The RBI has several official forecasters who have predicted a much slower growth rate for 2008-09 than the 8-8.5% mentioned in the policy statement. 'Exaggerated bearishness' can also refer to the stock markets with their enormous price swings.
Majority of India's population lies close to the poverty line and inflation acts as a 'Poor Man's Tax'. More than half of the income of this group is spent on food and this effect is amplified when food prices rise. The dramatic increase in inflation will have economic as well as political implications for the Congress Government, with an election due within a year.
Economic growth rate in the emerging markets have slowed down but is far from over. The BRIC countries i.e. Brazil, Russia, India and China alone account for more than 3 billion people and with consumption rate increasing every year. It is expected that the high inflation rates will be there for a long period of time which is worrying news for the Indian Government.
Direct regulatory measures such as the reduction in import tariffs were adopted in order relax the supply-side pressures on various agricultural commodities. While adopting the direct measures, the Government realized that the relaxation of supply-side pressures would dampen inflationary expectations by increasing supplies in the commodities market.
However, these measures failed to have the expected impact due to the global market conditions. Government reduced the Customs duty on various items and for some items making it zero. Due to fundamental factors prices of various commodities increased and therefore the amount of imports required now became costly. Indirect measures include the Fiscal Policy by the Government and the Monetary Policy by the Reserve Bank of India to ensure that less money chases fewer goods, thus reducing demand-pull inflation.
The RBI's attempt to control excess liquidity in the market by raising the interest rates pushed up real-estate prices as well as the commodity prices, thus fuelling inflation.
A closer look at certain commodities would reveal that the prices of sugar and wheat were managed by the Government through various market intervention mechanisms. As a result the physical market's role in effective price discovery was affected.
Trade in the commodities market operated in an asymmetrical information situation from both the supply and demand sides. Hence, market operations could only benefit segments that were privy to the available information. The existing agricultural market ecosystem revolves around the traders and to some extent the producers with no say from side of consumers. Hence, at the end both consumers and producers are often at a loss. Generally, traders keep a heavy margin to compensate for the physical and financial risk involved in carrying the commodity for short as well as long term.
Many small scale traders operate on a low scale and do not borrow. Therefore they undertake small scale operations which require large number of intermediation before goods can move from the farm gate to the consumer's plate, and they earn higher margins. The mark-up at each stage pushes up the final price without benefiting the producers.
At the end I would like to conclude with what D.G Prasad said about inflation "The inflation story is really a tale of what comes first, chicken or egg - that is, whether the inflationary pressures are driving the commodity prices or the commodity prices are causing the current inflationary trend".
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