The inflation problem continues to fox economists and unsettle ordinary Indians. However, the metaphorical man on the street seems to have had a better sense about the soaring arc of prices than the men and women with econometric models.
A year ago, the overwhelming consensus among Indian policymakers and private sector economists was that inflation would begin to decline to more reasonable levels in the quarters ahead. For example, the Reserve Bank of India (RBI) had said in April 2010 that inflation would be at 5.5% by the end of the fiscal year. Meanwhile, the 4,000 urban households that the central bank surveys each quarter to assess their inflation expectations were more pessimistic. They had indicated in December 2009 that inflation would be in double digits in the first three months of 2011.
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The latest inflation numbers for February show that the man on the street was closer to the correct estimate than the economists. Prices continue to surge. Inflation hovers around double digits. The revised inflation number for January is 9.4% and the first estimate for February is 8.98%.
One explanation why households have got a better handle on the trajectory of inflation than the experts is that information distributed in a complex system such as an economy is better captured by a large group of people than a single model: the wisdom of the crowds. A less Hayekian explanation is that the man on the street was just plain lucky, a factor that has a greater role to play in the prediction game than most participants would accept.
It is the third possibility that is the most worrying. The wide gap between official inflation forecasts and the expectations of ordinary citizens could be an indication of a serious problem—the lack of institutional credibility. In short, common wage earners and consumers discount the guidance given by the finance ministry and RBI on inflation. And they have diminishing confidence in the ability of these authorities to control prices.
To be sure, the entire blame for the surge in inflation cannot be laid at the doors of the government and the central bank. There is a structural element in the inflation trend, as higher incomes have raised demand for fruit, meat, vegetables and milk. Some inflation has also been imported, as global oil and commodity prices have shot up thanks to the strong economic recovery in emerging markets and loose monetary policies in most Western economies. But domestic cyclical factors are undoubtedly a big part of the story as well.
Higher global commodity prices are already pushing up input costs for most companies. High inflation expectations could fuel demands for higher wages as well. Whether these two factors have an effect on final prices depends on the ability of Indian companies to pass on higher costs to consumers. The International Monetary Fund said this month that the output gap has closed; companies are operating close to full capacity. The ability to pass on higher costs to consumers is usually strong at such points in the business cycle, since there is little excess capacity to ramp up production.
The usual short-term response to an outbreak of high inflation is by cooling demand. RBI will have to raise interest rates far more aggressively than it has till now. The government has already announced a fairly ambitious plan to cut the fiscal deficit. Higher interest rates will weigh down on private demand and less red ink in the national budget will keep government demand under control. Both strategies will mean that some economic growth will have to be sacrificed. The closest we have had to an official recognition of this hard fact is when Montek Singh Ahluwalia, deputy chairman of the Planning Commission, said after the release of the new inflation data on Friday, that the economy is unlikely to grow at 9% this fiscal.
However, as this column has pointed out earlier, demand management can work only in the short term. Further, it will involve sacrificing some growth. The more sustainable response will have to come from the supply side, through more investments and higher production capacity in farm and factory. I fail to see how such supply side effects can kick in without policy clarity and more economic reforms.
A final point: the Economic Survey released by the finance ministry in February used simple calculations to show that the Indian economy is quite capable of growing at 9% a year. India has an investment rate of around 36% of gross domestic product. India requires four units of capital to produce one extra unit output.
But what the finance ministry left unsaid was: 9% growth at what inflation rate? The recent past reiterates an old truth. The Indian economy cannot grow at over 8% for more than a few quarters without overheating.
Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at email@example.com