Recent months have seen an appreciable cooling of inflation. Data for November shows that Wholesale Price Index (WPI) inflation rose by just 7.48% on a year-on-year (y-o-y) basis from the same period last year. Food inflation, often a more pressing concern for citizens and the government alike has cooled a bit. Non-food manufactured product inflation, while picking up gently, remains within the zone of comfort.
All this has been used to suggest that the Reserve Bank of India (RBI) should take a pause in its rate increasing drive.
This outlook is misleading and is based on a misreading of the available facts. One such piece of information often ignored while making a prognosis of inflation, is the level of inflationary expectations. RBI releases this data gathered through surveys periodically.
The latest round for the July-September period shows that households expect inflation to rise in the next one year (October 2010 to September 2011) to 12.7%.
The question to be asked is what explains this “gap” of 5.2 percentage points between existing inflation (7.5%) and expected inflation a year ahead (12.7%)? This gap points to the possibility of an inflationary “catch-up” between now and the post-March 2011 period.
Some would argue that these fears are overblown. They are not, for three reasons primarily. First, the decline in inflation as seen through y-o-y numbers is deceptive as much of the cooling is due to the base effect. Inflation may come down to RBI’s “comfort” level of 6-6.5% by March 2011, but a look at the weekly and month-on-month data show that sequential momentum of inflation remains high. In fact, if inflation numbers are seasonally adjusted, WPI inflation is likely to be closer to 8-9%.
Two, it has been suggested that most of the recent spikes in inflation are due to food and fuel prices over which rate increases have little effect as they are supply side problems and not fuelled by more money chasing fewer goods. There is another way to look at this and this is where inflationary expectations kick in: An increase in expected inflation in the current period leads to an increase in actual inflation later. Higher food and fuel inflation are sure to fuel more inflation through demands for higher wages and, hence, higher costs to firms.
Three, it is true that managing inflation is not always about monetary policy. Loose fiscal policy has a lot to do with making inflation a structural problem. Galloping rural incomes coupled with slow growth, if not stagnation, in agriculture will ensure that inflation is not about to cool anytime soon, happy data notwithstanding.
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