A vicious inflationary circle

Monetary policy stance unlikely to make any difference

Both the consumer price index (CPI) and wholesale price index (WPI) numbers for March were published on Tuesday. Both tell a similar story; inflation may be subsiding but it is certainly not giving up without a fight. With CPI inflation having been designated the benchmark for monetary policy, its move up to a year-on-year rate of 8.3 per cent from eight per cent a month ago should be a cause of some concern to policymakers, both those in office and those expecting to be. While food prices are still playing a significant role, with the food and beverages group showing an inflation rate of just over nine per cent, clearly, other components of the basket are holding firm as well. The prices of services, which comprise a significant proportion of the non-food component, just refuse to moderate. The simple explanation for this is that they are predominantly driven by labour costs, which in turn are significantly driven by food prices. Food inflation, therefore, is feeding directly into CPI inflation in a way that monetary policy, which admittedly has no direct impact on food prices, simply cannot contain.

WPI inflation also went up relative to February, from 4.7 per cent to 5.7 per cent year on year. Like in the CPI, food prices contributed, but only modestly. The increase in the prices of manufactured goods, at 3.2 per cent, was higher than the 2.8 per cent in the previous month. Given the clearly sluggish growth situation and the fact that most manufacturing sectors are complaining of idle capacity, it might seem surprising that the inflation rate actually accelerates. But that is exactly what it has done. Again, the most plausible explanation is that food inflation - even though modest by recent standards - is still high enough to exert unrelenting pressure on wages, which then have to have some impact on producer prices. That not all increases in input prices can be passed through to consumers will no doubt be demonstrated if corporate fourth-quarter results, to be announced over the next few weeks, show low or narrowing profit margins. But some pass-through inevitably takes place, resulting in the kind of stickiness that is now being seen.

There is a vicious circle at work here. The Reserve Bank of India (RBI) is working on the basis of the dominant monetary paradigm that a tight stance is required to quell inflationary expectations. However, if these expectations are being driven not so much by monetary policy actions but by the daily ground reality of rising food prices, the question logically arises: is the current stance going to make any difference at all to inflation? And, if not, should the RBI now accept the logic that it is better off focusing on growth by lowering interest rates rather than sticking to its current position? These are complex questions. On the first, there is little doubt that drastic policy actions on the food supply front are really the only way to break out of this trap. On the second, however, the risks inherent in a change of direction - in terms of both outcomes and central bank credibility - must be taken into account. Just as the rest of the government is in suspended animation pending the election outcome, so should the RBI be.