Consumer price inflation in India has been close to or above double digits for nearly two years, and the more cyclically sensitive wholesale price index, after dipping into deflation territory last year, has been steadily rising to surpass double digits.
The puzzle is simply this: why is inflation in India so stubbornly high and so much higher than other emerging markets, even those that are supposedly overheating, such as China, Korea and Indonesia, where inflation is closer to 3 per cent?
First we consider a few standard explanations.
1. The supply shock factor - relates mainly to agriculture. The weather Gods failed us last year, India’s agricultural output suffered a sharp drop as a result, supply declined and prices rose. The monsoon is looking better this year, so the agricultural shock factor will not have the same bite going forward. And fuel price increases should be of a one-off nature rather than an ongoing source of inflation. Moreover, rising prices are not restricted to agricultural goods and have now spilled over into other commodities: double-digit price increases are no longer confined to agricultural commodities.
Cure : Well, no one can do anything when Gods go crazy..!!
2. Policy shock - Prices of fuel have recently been increased, which is contributing to overall price inflation. Minimum support prices for agriculture have also been increasing. Further, in the face of agricultural supply shocks, price smoothing by the government through greater imports and faster depletion of domestic stocks has been woefully inadequate.
Cure : Better, more thought out policies, or counter policies. <please pour in your thoughts>
3. Overheating: the supply capacity of the economy is simply unable to match the demands on that capacity - Overheating in India can be an agricultural phenomenon or an economy-wide pathology. In either case, there is cause for worry because the implication is that the economy’s current growth rate of 7-8 per cent is above its potential or trend growth rate. In this view, and unless capacity can be significantly increased, attaining China-type double-digit growth rates will remain elusive.
In agriculture, a scissors effect seems to be at work. On the one hand, productivity growth, especially in pulses, is anaemic and possibly weakening further. On the other hand, purchasing power and hence demand are accelerating, courtesy the NREGS (which is increasingly looking like a pure cash-transfer programme).
For the rest of the economy, they could be inadequate investment in infrastructure, inadequate supplies of skilled labour (always a possibility in India because its growth model is so skills-reliant), slow total factor productivity growth or some combination of all the three.
Cure : Given the capacity situation, aggressive monetary policy action will be warranted to bring inflation below 5 per cent..where political pressures come into play while tightening rates, etc.
4. A type of cost-push inflation - Serious micro-economic distortions afflict the land market . In itself, this distortion cannot cause inflation because presumably the distortion leads to a one-off increase in the price of land as an input. In other words, the distortion, unless it is continually worsening, will have increased the price level but cannot cause price inflation.
(meaning of the above para in a more layman language, correct me if I have explained it wrong: that due to whatever reason prices at some places may be sold at higher rate than the market rate, which keeps happening all the time, but that does not mean that the market prices have changed)
But suppose that these micro-distortions interact with macroeconomic factors such as surging capital inflows into real estate and housing. Such surges will lead to sudden increases in the price of land and related inputs, raising the cost of production in the economy as a whole.
A whole range of services, such as retail, construction, entertainment, education and finance — which account for progressively larger shares of the economy — use significant amounts of land as an input, a fact that gets overlooked in inflation discussions, which tend to focus on agriculture and manufacturing (this may also explain why inflation in consumer prices, which reflect services to a greater extent than wholesale prices, has tended to be above wholesale price inflation).
Generalised cost-push inflation could then be a natural consequence with the push resulting from the interaction between a pre-existing microeconomic distortion and a macroeconomic factor that serves to aggravate this distortion, converting a price-level effect into an inflation effect.
Cure : Microeconomic : Clearly, the first best solution is to eliminate the distortions in the land market of which there are many, including urban land ceiling and tenancy laws. The resulting boost to productivity would increase the overall supply capacity of the economy, making inflation less likely. Structural reforms of the land market will thus be good for inflation and good for growth.
Macroeconomic : But if land market reforms are infeasible, and inflation continues to be above acceptable levels, policy-makers may have little choice but to address the macroeconomic factors that aggravate the underlying distortion. In some cases, this may require dampening foreign capital flows, especially those going to real estate and housing; or they may involve other prudential measures such as higher provisioning requirements for real-estate lending.
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