Is rising inflation the result of fiscal profligacy, monetary largesse, exchange rate policy or the cost-push effect of food and fuel prices? Is the government or the Reserve Bank of India (RBI) to blame or the “foreign hand”? While economists will differ on the answers—they would not be economists otherwise—some elaboration of facts may make the discussion more interesting.
First, the Wholesale Price Index (WPI) is an incomplete measure. As a commodity index, it excludes services such as rent, health care, education, transportation, i.e., about 30% of the average consumption basket. This is being addressed, but slowly. Neither does it reflect the current situation. The inflation number issued every week is the year-on-year (y-o-y) change in WPI, comparing prices today with prices a year ago. Internationally, the usual measure of inflation is a seasonally adjusted month-on-month change which, masochistically, neither the finance ministry nor RBI wants. Further, as an overall index, it conceals differences in components. Unadjusted four-weekly moving averages of week-on-week data in Figure 2 show that while overall inflation is following an upward trend, in line with prices of manufactured products, food inflation, though variable, is moving downwards. If so, the aam aadmi (common man) may see lower food prices soon, making inflation less electorally salient.
Y-o-y inflation, however, is likely to persist. Last year, July and August saw relatively low price increases, especially for manufactured products, and this base effect alone may push inflation above 12% y-o-y, even if prices remain unchanged or even drop slightly. With stable fuel prices, other prices must fall steadily if overall y-o-y inflation has to drop to single digit by August.
Such quibbles aside, what is driving inflation? Put simply, it is manufacturing prices, which have risen by 10.3% over the last year and which make up 63.7% of the WPI basket, as shown in the first panel of Figure 1.
Consider the following thought experiment. What would happen if inflation for each of these groups had stayed the same as in January, as in the second panel? As the third panel shows, if manufacturing inflation were to decline to its level in January, i.e., 4.6%, overall inflation would fall by 3.2% to 8.4%. Removing the externally induced rise in fuel prices (16.2% over the past year) reduces another 2.7%, lowering inflation to 5.7%. The rise in food prices, which makes up 15% of the WPI basket, is actually the lowest in the five groups at 6.3%. Indeed, if prices of food had not changed at all in the past year, inflation would fall by only 1%. While other products (15.9%) and minerals (45.6%) rose sharply, their combined weight (7%) is too low to make a difference.
The data makes it difficult to absolve manufacturing. Till the recent hike in oil prices, y-o-y inflation in manufacturing has been more than food and fuel in 19 of the first 22 weeks of 2008, as Figure 3 shows. While global food and fuel prices have risen, this is not as much the case in India.
As expected from a sector which benefits most from productivity increases and a healthy dose of competition, manufactured product prices have risen the least in the past. So, why have they suddenly started to rise? Is it the cost-push effect of input prices or something more sinister?
Are manufacturers exploiting the decline in surplus capacity and the rise in incomes, which dampens the negative effects of price increases (in economic jargon, using positive income elasticity to neutralize negative price elasticity) to raise prices? Are they taking advantage of the government’s continued dithering over establishing an effective competition regulator? Is this pricing power the real reason behind growing corporate earnings, rather than higher productivity?
To be fair, there may be other real pressures on costs, for example, wage hikes engendered by a dwindling supply of skilled workers, higher costs due to the absence of infrastructure—bad roads (tolled or otherwise) add to transportation costs and fuel price increases raise the cost of captive power made necessary by a stalled electricity distribution reform agenda (it now costs Rs10 to generate a unit of electricity using an efficient diesel generator).
Whether it is lax regulation, inadequate training or poor infrastructure; if these are the reasons for higher manufacturing prices, lower food and fuel prices may not bring inflation back below 5%. These problems are structural and need far more governance to fix than we have seen this century. Traditional policy instruments have traction only to the extent that inflation is due to the opportunistic exploitation of demand pressures created by fiscal and monetary laxity.
But, whatever story you hear, keep some salt handy. According to the WPI data itself, the iron ore price index rose by more than 47% in the fourth week of January, and stayed almost unchanged since. The manganese ore price index rose 3.2 times in the third week of April, dropped back to its exact original levels in May, and rose by exactly 3.2 times again in the second week of June! Added to this are reports that government data collection personnel are leaving every week. How much can we trust WPI, on which we base our policy and politics? There is much that needs to be fixed. Or, is perception to be our only reality?
Partha Mukhopadhyay is senior fellow, Centre for Policy Research, New Delhi. Comment at firstname.lastname@example.org