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Using futures to control inflationary pressures

Using futures to control inflationary pressures
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First Published: Mon, Jun 02 2008. 09 50 PM IST
Updated: Mon, Jun 02 2008. 09 50 PM IST
A well-known oncologist in Chennai who recently operated upon a relative to remove a cancerous growth alerted the latter’s son during the pre-surgery consultation against speaking to the patient about the surgery to shield him from panicking. The idea was to accelerate recovery and avoid post-operative complications.
The medical metaphor illustrates how inflation can be compared with cancerous growth to emphasize the crucial role of behavioural sciences in inflation management. Cancer is an excessive growth of cells, and inflation is a flare-up in the prices of items of common consumption that make them inaccessible to a larger section of population. So, the behaviour of the stakeholders should be managed better for any anti-inflationary measure to succeed.
Inflation, a function of prices themselves, is the net result of perceptions of the market participants about the value of a commodity based on its supply and demand and their reactions to it. Behavioural sciences come into the picture the moment the market reacts to demand exceeding supply estimates, or to short supply.
Perceptions about stocks of commodities are another key factor. Strengthening long-term stocks, essentially by using a long-term tool to curb short-term volatilities, is the solution. However, identifying the nature of stocks, whether public stocks or private hoarding (a short-term tool traders use to create volatility in the markets and benefit from it) is a challenge.
The behavioural theory also stresses that economic stakeholders react bullishly to perceived price hikes stoking it further. The reaction happens at multiple levels—at the individual, social-group and political economy levels.
At the individual level, a perceived price rise would lead us to the theory of inflationary expectations as propounded by J.M. Keynes during the early 20th century. Individuals with varied objectives would purchase and store commodities of consumption, trade and production. An individual consumer may tend to stock, at least for the short term, creating a short-term scarcity and, hence, a further price rise. Or, in anticipation of a price hike, they may demand higher wages, again leading to a further price increase. Producers or traders would always store and sell in a market where prices are expected to move up.
In the midst of all these rational choices, the question is: can this be prevented through micro-management? The cost of micro-management would be higher than the benefits it provides, and an inefficient bureaucracy would muck it up. Therefore, the solution would be to have an advance indicator of price rises and their origins, so that the root causes can be better addressed. It is to prevent inflation from occurring rather than trying to cure it after it starts moving up.
There are many devices to gauge inflation expectations, including forecasts by renowned institutions, and individual analysts and economists, information emanating from the financial markets (debt markets, for example), and information flowing from trading of commodity futures and indices on the exchange platforms, to help policymakers take better preventive measures.
Indeed, commodities are the root cause of inflation in any economy and, hence, we looked at the possibility of Multi Commodity Exchange of India Ltd (MCX) commodity futures having indicated the high price rise that could happen in April 2008 (through the prices of April maturity contracts) about two months ago, in February 2008.
The April prices of these commodities had indicated an expectation of 7.7% price rise after adjusting for the carrying costs two months ago. Though the selected commodities constitute only about 2% of the gross weights of the Wholesale Price Index, the futures markets had already indicated a possible price rise in those commodities.
These futures, being individual in nature and unlike any other composite indicators, can make the policymakers’ task of targeting price-control measures more effective, and controlling the inflationary pressures at their very origins, better. In fact, futures prices discount the best possible information about relevant domestic and international fundamentals, policy decisions, and market sentiments. If these price signals can help the market stakeholders to take effective production, consumption and marketing decisions, why not the country’s economic managers?
Traders or producers would stock commodities in a rising market, and this tendency would increase with increase in market volatility, particularly in a northbound market. Again, price volatility is inversely related to the transparency in information about the price-moving factors.
Thus, in a way, the producer is paid only for the real scarcity of the produce and not for lack of information about it. Healthy futures market trading would help bring in transparency in the market and prevent inordinate price movements as well as hoarding.
It is necessary for the government or the managers of the political economy to get price signals in advance, so that they can better plan inflation management in such a way that the stakeholders in the economy do not know about them and hence, do not react irrationally.
The commodity futures market can definitely provide clues well in advance and, thus, help policymakers deal with the behaviour of individuals and groups, as well as the markets in which they participate, and hence, the economy.
The author is chief economist at the Multi Commodity Exchange of India Ltd. These are his personal views and do not reflect those of the exchange.
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First Published: Mon, Jun 02 2008. 09 50 PM IST