0115 966 7955 Today's Opening Times 10:00 - 20:00 (BST)

The Measures To Control Inflation

Published: Last Edited:

Disclaimer: This essay has been submitted by a student. This is not an example of the work written by our professional essay writers. You can view samples of our professional work here.

Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Inflation is a sustained rise in the general level of prices of goods and services over a period of one year. In other words, it indicates the percentage rise in the general prices today compared to a year ago. The rise (fall) in inflation mans that purchasing power of money declines (increases). This measure is very useful in understanding the trends in cost of living and also in comparing the trends in major macroeconomic variables. From the policy point of view, particularly for the monetary authorities, tracking of inflation is quite essential in formulating necessary growth policies.

In the recent period, India has been witnessing very high inflation rates and this has become a serious policy concern as it could have adverse impact on both growth and welfare of the country. The recent data shows that the headline inflation in May 2010 is at 10.16%, against the RBI's comfortable level of around 5%, as stated in the April 2010 Annual Credit Policy statement. In this context, here we look into the recent trends in the inflation rates (both headlines and also the subcomponents) and the main drives of these high rates. In the end, some discussion on the policy options that might help in containing inflation would be specified.

RECENT TRENDS

Before we look into the recent trends in the inflation rates, we need to understand the existing measures of inflation. As in any economy, India also has two broad estimates that cover the prices in whole sale market (which is called Wholesale Price Index (WPI)) and the retail market (Consumer Price Index (CPI)). Within CPI there are three sub indices that cover three groups namely industrial workers, urban non-manual employees and agricultural laborers. But there is no consolidated CPI for the whole economy. In the case of WPI, the index covers only the prices of goods and not the services, thus, making difficult for the policy makers and researchers in choosing the appropriate price index for target and also for research. However, WPI is the one that is tracked by the analysts and policy makers as the information flow is faster with WPI compared to CPI, which comes with a lag of two months.

It is also generally assumed that any changes in the prices in wholesale market would eventually transmit (or pass-through) to the retail market. Hence, WPI might be a better indicator for tracking the general price level in the economy. However, a look at the graph below shows that the convergence between WPI and CPI inflation is quite weak, particularly during the high inflationary periods, and also takes a long lag. Thus, this divergence in price indices also results in divergence in the policy impacts as well.

The recent trends in the inflation numbers show that India is experiencing high inflation situation since the end of 2009 and currently it is at an uncomfortable level of 10.16% in May 2010 and there are expectations that this would increase further. At the disaggregated level, one may note that the prices of both food and non-food and the fuel group are increasing sharply since the middle of 2009, while the inflation rate in the manufacturing sector was almost subdued at around 6% for a long time. As minimum rise in the inflation rate acts as an important incentive for the production activity, this could have adverse impact on the consumption and could particularly affect the poor who are largely not indexed in India. Based on this, our own studies in the past have shown that the threshold (or the optimal or tolerant) inflation for India is at around 4 to 4.5%. Policy makers (particularly the monetary authorities) would try to contain the inflation at around this range. Although India does not follow the inflation targeting regime (where the inflation rate should be controlled at a level fixed by the legislation.

For instance, UK has fixed the inflation target at 2%), it is generally clear from the policy statements (such as manual Credit policy) that the Central Bank would try to control the inflation once it crosses the 'comfortable level'.

CAUSES OF HIGH INFLATION

As discussed above, currently, in May 2010, the WPI inflation is above 10%. Monetarists, led by Nobel Laureate Milton Friedman of Chicago School, across the globe believe that 'in the long-run, inflation is always and everywhere a monetary phenomenon'. This means that the money supply growth is the major determinant of inflation and in the long run higher inflation rate can be controlled only through tight monetary policy. But there are other competing schools, such as Keynesians, that say that money is not so important rather than the aggregate demand caused by private and government spending that determines inflation.http://www.mbaknol.com/wp-content/uploads/2010/09/inflation_mbaknol.jpg

Hence, Keynesians suggest that money is not the one determinant of inflation. Money has a role only when its growth is higher than the economy's capacity to absorb. There is also a view that explains 'cost-push' version of inflation, which is largely due to supply-shock that results in fall in aggregate supply. Overall, while there are many theories that explain the causes of inflation, based on enumerable empirical studies, relying on one school of thought might not be wise. In India also there were many studies on inflation determinants and their conclusions are quite diverse.

As the behavior of inflation is very dynamic the theoretical explanations of this behavior could also be dynamic. Hence, this needs to be examined on a regular basis.

INFLATION AND GROWTH CONCERNS IN INDIA

Two sets of recently released figures on the economy - the Index of Industrial Production (IIP) and inflation - have set off an interesting debate about the direction of our monetary policy. The RBI has become caught between the never ending debate about making a trade-off between inflation and growth.

Recently released CSO data on the IIP indicates that industrial growth decelerated in January 2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical engines of industrial and consequently economic growth - consumer durables and capital goods. While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG, consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food products, beverages, tobacco etc showed double digit growth. The growth rate of the core infrastructure industries group - crude petroleum, petroleum refinery products, coal, cement, electricity and steel - which has a 26.7% weight age in the overall IIP fell from 4.2%in January, compared to 8.3% in January 2007.

Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5% tolerance level in the third week of February and continues to rise. WPI based inflation rate breached the critical 5% mark to close at 5.11% for the week ended March 1, 2008, the highest in over nine months. It further rose to 5.92% when the latest figures were released for the week ended March 8, 2008, to reach the highest figure since May 7, 2007. The prices for cereals increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron and steel 20.87%, and edible oils 17.52%.

C:\Users\DELL\Desktop\my assignments\RESEARCH ASSINGMENT- 2ND SEM\IIP Apr-Jan 07-08.jpg

There are many reasons to doubt that the drop in capital goods is not part of any long term trend. For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable, given the strains it would place on an already stretched out economy. Investments in the main consumers of capital goods like infrastructure have been growing and shows no signs of slackening. The order books of the main capital goods manufacturers remain buoyant and their sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by about 33 per cent in the last quarter of 2007, in comparison to the same period last year.

C:\Users\DELL\Desktop\my assignments\RESEARCH ASSINGMENT- 2ND SEM\Inflation in food prices.jpg

The already committed investments in these sectors may be enough to sustain the present capital goods growth trends in the near future. The projected expenditures in these non tradable services like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive, are by themselves capable of sustaining very high growth rates. The Government's own flagship programs like the Golden Quadrilateral and other National Highway projects, PMGSY, JNNURM, and the programs to promote PPP in core infrastructure, should provide more than adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The demand for both residential and commercial real estate is both massive and ever growing, and has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and cement, after a blip in January, exhibited robust growth in February.

The construction sector, which encompasses all these infrastructure investments, exhibited one of the lowest sector ICORs in the Tenth Plan period at a very low 1.2. It has also been shown that construction sector generates one of the highest employment rates for every rupee investment. All this will ensure that the economic multiplier will be significant from these committed and projected investments. So any talk of a major slowdown may be not based on any logical foundations.

The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby spurring consumption and boosting industrial and business activity. The consumer durables sector, especially two-wheelers and automobiles, is expected to be one of the largest beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 billion in the hands of consumers, thereby providing a major fillip to manufacturing demand. These are all strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the corporate investment climate healthy.

MEASURE STEPS TO CONTOL

The Government have responded to the rising food and commodity prices by piecemeal and stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures trading (on food grains). These efforts are based on the wishful but futile assumption that it is possible to insulate the Indian economy from the global trend of rising food and commodity prices. This attempt at importing deflation by freeing up the external sector has severe limitations, given the small quantities involved in such trade and the high prices prevalent in the global markets.

The rising global commodity prices, both food and non-food, has pushed up import prices. Addressing this inflation with monetary policy levers may not only not yield results, but may backfire badly, especially at a time when growth itself is slowing down. That the inflation is not driven by demand side pressures is also clear from the fact that growth in money with the public has declined form a very permissible 17% to an even less 14% in February, 2008. The RBI figures show that money supply which has been growing at 22.2% annually is slowing down to an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones.

The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production, declining private capital investments in manufacturing, and over-stretched infrastructure, especially power and transport logistics.

The domestic supply side factors that are driving inflation need to address through some immediate policy interventions. Infrastructure bottlenecks are an immediate priority that will continue to strangle any economic growth. It is impossible for India to grow at double digit growth rates, by maintaining low inflation, without massive investments in its creaking infrastructure. Agriculture investments, both physical and those aimed at improving productivity, have been declining and this is manifested in the stagnating production, thereby forcing imports. This needs to be addressed immediately on the highest priority, especially given the large share of population dependent on agriculture.

The external sector has also been a significant determinant on price increases. Since 2004, import prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from $225 per tones to $510 per tones. Our import basket has taken an enormous hit, and naturally inflationary pressures have been building up. Commodity prices worldwide - food grains, cash crops, energy and metals - have been growing at an alarming rate. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent.

All this will also reduce the demand for oil and other energy supplies. Economic growth in the merging economies too will drop, though not sharply, thereby further reducing domestic demand in these markets. All this is likely to result in lower commodity prices, which will benefit large domestic market and commodity import dependent economies like India and China.

What should the Government do at such times?

Such times are a strong reminder of the continuing need to maintain a robust and effective Public Distribution System (PDS), which would help insulate at least the poorest of the poor from global economic volatility. It is also a reiteration of the importance of food security, and the need to make investments in agriculture with the objective of increasing productivity and thereby expanding production. There is very little Governments can do to control the rising commodity and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve precious little. Aggressive promotion of investments in infrastructure will be important for easing the constraints faced in a sector vital for promotion of overall economic growth.

These times also highlight the immense complexity involved in aggressively interventionist market controlling approaches like price controls and duty hikes. Therefore, in such circumstances, if the Government decides to assist a category of consumers with some subsidy, it is more appropriate that such subsidies be transferred as direct cash transfers than by meddling with the price mechanism. Such measures are better able to co-ordinate with the market and deliver the full bang for the buck. Besides, it will also prevent market distortions that have consequences that often go much beyond the duration of the crisis itself.http://4.bp.blogspot.com/_3HP-yPoJm6o/S815Ha_rSxI/AAAAAAAAAB4/qlg_Pxy18F8/s1600/rbi.jpg

What should the RBI do to ward off inflationary pressures or CONCLUSION?

It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but at least by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.

It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head. In fact, we should have lowered the interest rates late last December itself, in anticipation of such a reality, given the storm clouds that were then gathering around the US economy.

For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.

In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.

Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.


To export a reference to this article please select a referencing stye below:

Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.
Reference Copied to Clipboard.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:


More from UK Essays

We can help with your essay
Find out more