Abheek Barua: Rate hikes soon?

Recent reports on retail prices for food items are alarming

If prices continue to rise, will the first steps towards monetary tightening be taken by the year-end, asks Abheek Barua.

How concerned should we be about inflation? If I go by recent reports on retail prices for food items, there is cause for alarm. Prices of most food items have picked up sharply over the past few weeks on drought concerns. The escalation is not confined to grains and pulses alone — there appears to be considerable spillover to things like meat and fish prices as well as vegetables. Edible oil prices and sugar have ticked up substantially.

If these reports indeed reflect what is happening across the country, then retail price inflation would have really flared up over the past few weeks. Unfortunately official consumer price index-based inflation data comes with a long lag and there is no comprehensive pan-country index.

 

However, we do have the wholesale price index that comes with a fortnight’s lag. While the index need not necessarily capture retail price movements to a tee, it does give a fair idea. Going by the food price index in the wholesale basket, inflation measured year on year for the week ending August 15 was 11.5 per cent. Between July 18 and August 15 (a period of just a month), the index went up by 4.2 per cent. If I annualise that, it works out to an inflation rate of 48 per cent.

This spike in prices is clearly being driven by a supply shock coming on the back of the drought. Monetary policy is unlikely to be effective in tackling this in the near term. The only thing that is likely to work in the near term would be more efficient public management of food supply. Higher interest rates will not bring rice prices down; making more grain available at ration shops will.

The medium-term policy options could, however, be somewhat different. The choice of instruments to tackle inflation might not be as simple or the analysis as simplistic if agricultural prices remain firm and other components of the index also start to drift up. The bottom-line is that the RBI might have to flex its monetary muscles as early as the end of the year.

The RBI’s problems could be compounded by a couple of other things. The ‘base-effect’ of exceptionally high price levels last year that tend to pull inflation down this year starts to lose its punch by October. Thus there is a natural upward drift in the wholesale inflation rate that is conventionally measured year on year. Our estimate is that given a combination of a sequential increase in prices and the dwindling base effect, headline inflation will be close to 6 per cent by the end of December and climb all the way up to 8 per cent by March.

The second risk stems from a possible rise in international prices of agricultural items. While these have picked up from their February lows, their rise has been much lower than other commodities. Thus while the Reuters-CRB index has picked up by about 21 per cent between February and mid-August, the sub-index for agricultural commodities moved up by just 9 per cent. Given the fact that there are supply shortages in agriculture across the world, I would not be surprised to see a sharp up-tick in soft commodities in the next few months. Thus if we have to rely on imports to bridge the domestic supply gap, these could come at much higher prices than are prevailing now.

If monetary policy is unlikely to curb prices in the near term, can it hope to achieve much in the long term? To put it more crudely, if high interest rates can’t tame rice prices in the short term, can they do much in the long term? Let me try and outline a central bank’s argument for resorting to monetary measures even when the source is quite visibly a supply problem.

The real objective of monetary action, central bankers would argue, is not so much to manage the current level of prices but to tame inflation expectations. Inflation expectations are what really matter because they help to embed price pressures in the economy. Thus what starts as a supply shock restricted to a particular commodity translates into a long phase of high inflation, spread across commodities if these expectations are allowed to persist.

Inflation expectations are known to thrive on high liquidity. One reason for this link perhaps is that it becomes easy to take speculative positions in commodities (whose prices are on the rise) if liquidity is easy. This breeds a vicious cycle of rising spot prices and a further increase in expectations. It is, for example, easier for a speculator to hold large stocks of commodities if the cost of holding or ‘carry’ is low. Holding costs depend on liquidity and thus higher the liquidity, easier it is to hold back large stocks and perpetuate price pressures.

The argument against tightening policy at this stage is that current growth levels are significantly below potential and thus monetary policy should remain neutral, if not accommodative. The RBI articulates its dilemma rather succinctly in its Annual Report released last week: “In such conditions, while withdrawal of monetary accommodation entails the risk of weakening recovery impulses, sustained accommodation and the associated protracted phase of high money growth can only increase inflation in future.”

Central banks are, however, known to fret more about high inflation than about growth in resolving their policy dilemma. They are also known to prefer to stay ‘ahead of the curve’, that is take proactive anti-inflation measures instead of letting inflation build up and then react. If all this is true and prices continue to follow their current run rate, should we be too surprised if the first steps towards monetary tightening are taken by the year-end?

The author is chief economist, HDFC Bank. The views here are personal