13 May 2022 14:55:31 IST

A long-time ‘deskie’, Baskar has spent much of his journalism career on the editorial desk. A keen follower of economic and political matters, he likes to view economic issues from a political economy lens as he believes the economic structure of a society is deeply embedded in its political and social ethos. Apart from writing the PolitEco column for BLoC, Baskar writes book reviews and articles on politics, economics and sports for the BL web edition. Reading and watching films are his other interests, though the choice of books and films are rather eclectic.  A keen follower of sports, especially his beloved Tottenham Hotspur FC, Baskar is an avid long-distance runner.  He hopes to learn music some day!

What is driving India’s inflation?

Just as the Reserve Bank of India hiked policy rates in a surprise move last week, retail inflation in April jumped to 7.79 per cent from 6.95 per cent in March. April’s retail inflation print is the highest since May 2014. 

The RBI had on May 4 hiked the repo rate by 40 basis points to 4.4 per cent and the cash reserve ratio was hiked to 4.5 per cent to cool down inflation. The repo rate is the interest rate that RBI charges commercial banks for borrowing from it if there is a shortfall in their (commercial banks) funds. Cash Reserve Ratio is a certain minimum amount of funds that commercial banks are mandated to park with the RBI. Central banks raise these rates to slow down the money supply. 

The usual culprits were ‘Fuel and Light’ at 11.03 per cent and ‘Food and Beverages’ at 8.38 per cent. 

Inflation is a subject that has confounded economists for long. After decades of research and theorising on this issue, economists are still agonisingly far away from getting a grip on this complex economic problem. 

Kaushik Basu, Cornell University Professor and former Chief Economic Advisor, has an interesting story in his book An Economist in the real world about how an eminent economist advising a small nation did not know what a repo rate was! 

This economist not wanting to reveal his ignorance, in his conversation with the country’s central bank chief tried to figure out what a repo rate was. After a few exasperating and amusing moments, the eminent economist had to admit that he knew nothing about repo rates but probably ended up lowering it by 100 basis points! 

This story is most likely to be apocryphal but it does give a glimpse of how complex the issues are. 

Inflation: Textbook vs reality 

Conventional economic theory points to two reasons for inflation. According to the first reason, which views inflation as purely monetary phenomenon, prices rise when the money supply exceeds its “natural level.”  

This is when the economy is supposed to have “overheated.” This theory makes two crucial assumptions — one, the economy is producing goods at full capacity, and two, it is functioning at full employment.  

Given these two assumptions there is no scope to increase the supply of goods, so prices tend to rise. To deal with this form of inflation central banks tamp down on money supply which leads to demand contraction, which is expected to cool down prices. 

The second view sees inflation as a supply-side phenomenon, where prices rise because there is a shortage of supply of goods. Here the economy still has the capacity and labour to produce more goods to meet the aggregate demand in the economy. Once the supply of goods increase, prices are expected to fall. 

The above two examples are of course highly stylised, textbook phenomena, which are only approximations of the real world. 

But the current inflation episode world over is a heady mix of both monetary and supply-side factors, entangled with each other. Firstly, central banks of the world over are winding up their easy money policies that they had put in place a couple of years ago to deal with the economic carnage of the Covid pandemic, as inflation in western nations is at a three-decade high. 

The US Fed has already started hiking policy rates and the European Central Bank has indicated that it will follow suit in July. 

The supply-side factors are ruled by the surge in global fuel prices since the Russia-Ukraine started in late February. This has led to cost push inflation increasing the prices of a host of goods and services that use fuel as an important input. 

In India, the food inflation is also due to the likely shortfall in wheat output due to an unusually hot April that has affected the wheat standing crop of the Rabi season. Also, farmers and traders and are eyeing the opportunity of wheat exports, given that the two major exporters — Russia and Ukraine — are unable to export.  

This is driving up wheat prices here and the government has already substituted wheat with rice in the PM Garib Kalyan Anna Yojana scheme in some States. 

Also, there are huge supply issues with edible oils, which is a major item in India’s import basket. Indonesia, a major edible oil exporter has banned exports creating a huge pressure on prices and supplies in countries like India. 

Farmers and food prices 

Another view that is gaining traction now is that rising food prices may not be such a bad thing as that would benefit farmers, especially given the declining fortunes of this sector in recent times. 

Somnath Mukherjee of ASK Wealth Advisors in a recent column argues that higher farmgate prices will benefit farmers and may even set off a virtuous cycle of consumption spurring demand in the economy. But this argument misses a crucial point.  

What percentage of Indian farmers are net buyers of food? If this percentage is high, then higher food prices will hit them too and the benefits of high food prices will accrue only to a narrow band of rich farmers. 

In this context that rural inflation in April at 8.38 per cent overshot that of urban areas at 7.09 per cent adds another worrying dimension to this problem. The food inflation in rural India at 8.35 per cent is higher than the 7.72 per cent in urban areas. 

More rate hikes imminent 

Going ahead, the consensus among economists is that RBI will hike policy rates by at least another 50 basis points in the next policy cycle. Many economists feel that inflation will be in the 7+ range for the next few months and is likely to cool down to the 6.5 per cent range only by October. 

The inflation situation is still evolving and given the bewildering array of factors at work (both economic and non-economic), no one can quite predict how things will play out in the next few months. Economists and central bankers with their sophisticated theories and econometric models seem no wiser either. Which is hardly surprising given how complex an entity the economy is.