Implications of inflation for India coalition

Implications of inflation for India coalition

New Delhi: Headline inflation in India may touch 11% for July, its sixth straight month in double digits, making high prices the single biggest political and policy challenge for a government voted in on a pro-poor agenda.

Why are prices high?

India’s headline inflation has been rising sharply since the middle of 2009 for several reasons -- a bad drought that hit farm output, higher fuel prices, supply bottlenecks. and demand-side pressures in an economy growing at around 9%.

Both consumer and wholesale price indices are now in double-digits, making Indian inflation the highest by far among large economies. Other factors fuelling price rises are the fact factories running at capacity, skills shortages, and a 33 percent annual rise in urban housing costs.

What could be the political fallout?

A year-long spell of double-digit food inflation has sparked street protests, and two weeks ago the opposition blocked parliamentary proceedings for a week over the issue.

The Congress party could be hit in major state elections in early 2011, including in eastern West Bengal and southern Tamil Nadu states. Inflation also worries Congress allies, two of which face elections in their stronghold states, and political expediency may force them to distance themselves from anything that angers voters.

But they are unlikely to bring down the government, and national polls are not until 2014.

What are the economic implications?

Stubbornly high inflation could dent economic growth, which is projected at 8.5% in the year ending March 2011. Aggressive monetary tightening to counter inflation could also lead to an increase in borrowing costs for the government which are projected at about $100 billion in the 2010-11 fiscal year.

It could also lead to a slowdown in the capital expenditure plans of corporates, possibly putting pressure on earnings.

A high interest rate economy also attracts more capital flows which will be useful for financing India’s current account deficit but could lead to a stronger rupee, hitting exports and putting pressure on the trade deficit.

Also, the government, with an eye on voters, has left open the option of intervening if global crude prices soar after lifting price controls on gasoline in June. If the government intervenes to subsidise fuel, it may impact efforts to keep the fiscal deficit below the forecast 5.5% of GDP in 2010-11.

Unless New Delhi accelerates efforts to improve farm output, it will be forced to rely more on costly imports and subsidies, exacerbating a stressed fiscal position.

What could the central bank do?

Inflation is now generalized and demand side pressures are clearly evident. The central bank has responded by raising interest rates four times since March, most recently on 27 July when it hiked the reverse repo rate by 50 basis points, more forcefully than expected to absorb excess cash.

With inflation a dominant concern and an economic recovery firmly in place, the stage appears set for more tightening. A Reuters poll after the 27 July policy review found economists expect the central bank to lift rates aggressively, with most forecasting a further increase in rates by 25 basis points by the end of September.

Will prices come down?

Unlikely in the near term. The growth-focused government appears resigned to elevated inflation, which has consistently outrun its forecasts.

Finance minister Pranab Mukherjee has said inflation is a price to pay for rapid growth. There are suggestions in the government of a “new normal" of inflation running at 6 to 8 percent, from the roughly 5 percent considered acceptable by policymakers in recent years.

Will a good monsoon help?

Maybe moderately.

Monsoon rains will slow rising food costs, while the base effect after a year of sharply rising prices will soon kick-in, pushing inflation down to single-digits. But other bottlenecks persist, including a gap between farm output and demand. High inflation has persisted despite tightening of monetary policy this year, including the shifting of the operative rate from the reverse repo to the repo.

But monetary policy is not enough to curb demand from India’s rural poor, who are spending their rising incomes on food. Foodgrain production has risen less than 1% a year in the past decade even as per capita incomes have roughly doubled.