There is a sense of euphoria on the state of the economy, with the growth rate in the first quarter of 2019 rising to 8.2% from 5.7% two years back. Cheerleaders of the government have already declared that the worst phase of the economy after the twin shocks of demonetization and the hurried goods and services tax (GST) implementation is over and the economy is back on track. Despite this, there is a sense of unease among the middle classes given the weakening of the rupee vis-à-vis major currencies and fuel prices which are at record levels. Even rural areas are going through a sense of unease, but their concern is entirely opposite with the majority of agricultural commodities going through one of the sharpest deflation episodes in recent times.

While the government may dismiss it as a political reaction which will subside in due course, the inflation numbers suggest structural problems in the economy, unlikely to be resolved in the short run. One of the successes that this government has claimed throughout is its ability to keep inflation down. Much of this was due to the sharp collapse of petroleum prices right at the beginning of the term of this government. But what has also kept it sustained over the years is the unprecedented deflation in agricultural commodity prices in the last four years. And it is this which may be the cause for worry for the economy.

Overall inflation in consumer prices has remained in the range of 4% this year, occasionally going to 5% for some months of the year. Same is true for inflation measured on the Wholesale Price Index (WPI) which increased to 5.7% in June of this year but has moderated since then to 4.5% by August, well within the range set by the Reserve Bank of India (RBI). But it is the composition of the inflation and its various constituents which present a worrying picture.

Since January of this year, overall inflation in food price index, with a weight of almost one-fourth in WPI has been only 0.3%, with food price inflation negative in the last two months. The deflation in primary food articles has been 2.2% in July and 4% in August of this year. The sharp deflation in food and agricultural articles does not augur well for the rural economy already suffering from untimely rains and a severe shock to the economy in the wake of demonetization and GST. One of the immediate confirmation of the severe demand deflation in rural areas is the decline in real wages which have now fallen for the last eight months.

Excluding primary food articles, inflation in the economy based on WPI has been 6.5% in June, 6.8% in July and 6.7% in August of this year, well above the tolerance band of RBI. It is this trend of very high inflation in non-food commodities and a sharp deflation in food commodities which makes inflation targeting a real challenge. One consequence of this has been the relative prices of food and non-food commodities which has declined sharply to 0.8 from more than 1 during the United Progressive Alliance (UPA) years. The decline in agricultural incomes, along with declining real wages, poses the single-most important challenge to revival of the economy.

One of the consequences of inflation-targeting by the monetary and fiscal authorities without looking at the nature of inflation has been that the effort at reducing demand has led to further decline in output and incomes much more than prices, thereby worsening the situation. This was achieved through reduction in public spending and also restricting credit growth which is now at the lowest in recent years.

At a time when sound economic policy would suggest raising demand in the economy through public spending and increasing access to credit, particularly in rural areas, government policy is geared towards expenditure reduction and restricting access to credit. Given the pressure on current account deficit and the fiscal deficit due to the rising petroleum prices and weakening rupee, any such effort of further reduction in public expenditure will be counter-productive. While it may score brownie points for sticking to fiscal discipline, it is ultimately hurting the long-term growth prospect of the economy. It is also time for RBI to realise that a blind belief in the policy of inflation-targeting without understanding the nature of inflation may have only limited relevance in the Indian economy.

Himanshu is associate professor at Jawaharlal Nehru University and visiting fellow at the Centre de Sciences Humaines, New Delhi