Inflation control: chasing a chimera

The average inflation rates in the first two quarters of 2011 on a year-on-year basis were 9.56% and 9.4%, respectively.

Should we split this inflation into core and non-core categories, then the rate hike story becomes somewhat prescient. Core inflation, or price rise in items excluding food, manufactured food and fuel, was 6.43% and 6.24%, respectively, in the March and June quarters.

In the Wholesale Price Index, core items, or non-food manufactured goods, have a weightage of 55%. Whereas, non-core items have 45% weightage, inflation in these items was prevailing at the rate of 13% plus during the March and June quarters. In other words, two-thirds of the overall inflation was contributed by the non-core sectors.

The rate increases by the Reserve Bank of India (RBI) have little impact on non-core inflation. Further, there is a feedback mechanism from non-core to core inflation operating through higher transport cost, higher raw material cost and higher wages. The impact of persistence of this shock can be econometrically estimated. We find that if fuel price goes up by say 10%, then 34% of it, or 3.4%, will be passed on to core inflation in three months. For this reason, given the volatility in food and fuel prices, the ability of RBI to contain core inflation, leave alone overall inflation, through rate hikes is somewhat limited.

The answer lies in smoothening the structural rigidities in food and fuel supply chains. Bringing down fuel inflation rate will depend on our ability to strike long-term contracts and in the pursuit of cost-effective raw material securitization measures in oil, gas and coal outside the country. Similarly, in the food sector, our ability to contain prices would depend on our ability to improve supply chain efficiencies. Development of organized retailing can have a catalytic impact in this context.

We have often been told that a rule-based policy rate hike is more robust than one which allows for significant discretion. For this purpose it is customary to examine the deviation between actual inflation and target (threshold) inflation and the deviation between actual output and potential output, along with their respective weightages for determining the signal rate.

Already a 275 basis points hike has taken place during the past 15 months. For reasons elaborated earlier, the inflation rate continues to prevail at 9% plus when the threshold inflation is around 6%, creating a perpetual gap of 3%. Rate hikes have done little to bridge it.

On the flipside, the 12-monthly moving average growth tells an interesting story. While the Index of Industrial Production was 9.3% in January, in May it came down to 7.4%. Capital Goods Index growth has come down from 21.2% to 12.2%, intermediate goods growth has come down from 8.4% to 5.8%, even consumer goods growth has come down from 7.7% to 7.5%. The decelerating growth trend is clear across the board.

Further, the hike in interest rate along with land and regulatory issues have led to many project delays. The new investment announcements fell from Rs5.7 trillion in March 2010 to Rs2.6 trillion in March this year. Further, growth in fixed investment shows a sharp decline in the three months ended March.

In other words, the actual output is falling way short of the potential. Hopefully, policymakers will keep it in mind while reviewing the interest rate.

Siddhartha Roy is economic adviser, Tata group. These are his personal views.

On 26 July the Reserve Bank of India will announce its quarterly review of monetary policy. Will it continue to tighten the policy with yet another rate hike to fight high inflation or will it press the pause button as growth is being threatened? This is second of a series that Mint will carry over this week in the run up to the policy.

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