In a speech at Hyderabad on Tuesday, Reserve Bank of India (RBI) governor D. Subbarao said that food inflation has become structural in nature, the result of higher rural incomes leading to a shift in dietary habits. He said the outlook on food inflation in the short and medium terms will be determined by the supply-side response from the government. That will take time and the implication is it’s not going to be easy to get food inflation down. As the governor points out, “we are experiencing high food inflation in the face of record production of food grains, robust buffer stocks and growing resilience of agriculture to monsoon uncertainties”.
But if inflation in India has become structural, as RBI says, does it mean we have entered a period when interest rates will remain high? As long as inflation remains sticky, RBI cannot afford to let down its guard. But does it make sense for the central bank to use monetary policy to tackle food prices? It has been argued that raising interest rates will do little to bring down food prices. But here’s what Subbarao said in a speech at the Stern School of Business, New York University, in September: “Rising incomes, especially in rural areas, have resulted in a shift in dietary habits away from cereals and toward protein-based foods. This is a structural change and monetary policy will be misled if it treats this as a one-off supply shock. Given the high share of food in the various consumer price indices (46%-70%), persistent supply pressures on the food front can fuel inflation expectations; and in the face of growing demand pressures, rising inflation expectations can trigger a wage price spiral. Recent reports that real wages of rural labour have gone up markedly suggest that such a wage price spiral may already be under way.” He’s saying here quite unequivocally that monetary policy needs to be tightened to take care of the consequences of rising food prices. He made a similar point in his speech at Hyderabad.
Rising incomes, social security programmes such as the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) and higher minimum support prices have all led to higher food prices. There have been plenty of reports about how MGNREGS has succeeded in pushing up wages of farm labour. Rising costs lead to rising output prices for farmers, which push up consumer prices. And since MGNREGS wages are indexed to the Consumer Price Index, wages increase and the spiral Subbarao talks about goes on. The solution, of course, is to increase supply, but that means increasing productivity, which is unlikely to happen anytime soon. And since it’s difficult to argue that the common man shouldn’t eat more but tighten his belt and wait for increased productivity, MGNREGS is likely to go from strength to strength. Also, importing food is not an option. The same structural reasons that have lead to higher food prices in India are operating in other high-growth emerging markets. A paper from the International Monetary Fund’s (IMF’s) research department earlier this year concluded “the main reasons for rising demand for food reflect structural changes in the global economy that will not be reversed”.
RBI has said that wholesale price inflation should fall to 7% by the end of March 2012. Slowing growth should lead to a drop in the rate of inflation in manufactured products, but rupee depreciation may throw cold water on the central bank’s hopes. Also, while the effect of a high base will help in creating a statistically lower inflation number, that impact will lessen later on in 2012, as the base effect comes off. Indranil Pan, chief economist at Kotak Mahindra Bank Ltd, says that inflation is not going to come down in a hurry after March. “And when we talk of high inflation, we should also talk of high interest rates,” he says.
Does it mean we’ve entered a “new normal” of high interest rates? We probably have. The caveat, of course, is that Europe doesn’t implode.
All the more reason, then, for fiscal policy to take some of the load off RBI’s back. If the government is able to prune its fiscal deficit, that would lead to less pre-emption of funds by the government and lower interest rates. The IMF staff reports for the G-20 Mutual Assessment Process warn that India needs to curb its fiscal deficit, particularly in light of recent market sentiment towards sovereigns that have high deficits. The report points out that subjecting financial institutions to high levels of mandatory government financing (in other words, the statutory liquidity ratio requirement) crowds out lending to the private sector and distorts interest rates, making it difficult to develop the private bond market and thereby finance much needed infrastructure investment.
But these are prescriptions—the political realities are rather different. Fiscal strains will in fact rise when the Food Security Bill is enacted into law and it will also lead to more pressures on food inflation. And so far there has been little progress in pruning subsidies.
According to the IMF staff papers, “India’s revenue share of GDP (gross domestic product) fell in the lower third of the distribution each year of 2007–10, among economies whose nominal US dollar GDP per capita was between $648 and $1,488 in those years.” In short, there’s scope to increase taxes.
Whether the government will be able to bite the bullet is, of course, doubtful and, given its track record, the odds are not favourable. But if it doesn’t act soon, interest rates could remain high for a long time.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com
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