Inflation has edged itself into the centre of the discussion on the state of the economy, not only in India but internationally. But it would be a mistake to infer from this that the cure for inflation in India would be the same as elsewhere. The acceleration of inflation in Europe is due to the rise in the price of oil following the Russian invasion of Ukraine. In India, though the recent spurt in oil prices would surely have had a role in its acceleration, the inflation itself is structural, in that it is related to the characteristics of the economy. This will be our argument here, but we first present the evidence.
We flag two aspects of the recent inflation in India. The first is the differential inflation across commodity groups. For the month of April, annual inflation in India was over 7 per cent but food inflation, or the rise in the price of food, was higher at over 8 per cent. It is a general feature of inflation in India that it tends to be led by the growth of food prices, which has a cascading effect on prices elsewhere in the economy. First, as a prominent part of the consumer price index, the price of food affects it directly, but it also impacts it indirectly through rising wages, and thus the cost of production in the non-agricultural economy. When wage changes respond to inflation with a lag, food price inflation will have a long-drawn effect on the economy, that is, inflation does not stop suddenly, even if food prices were to stop rising.
The second aspect of the current inflation is that it commenced some time ago. Annual inflation on a monthly basis began to rise from September 2020, and rose every month thereafter up to April 2021. At 6.2 per cent, inflation in 2020-21 was almost twice its level in 2018-19. So, what we are seeing now is only a small acceleration of an inflation that commenced over two years ago. Though the price of edible oils, which India largely imports, did shoot up in March, it would be fatuous to attribute the current inflation entirely to the war in Europe. It is more like we have woken up suddenly to an ongoing process. While the rising price of crude oil is surely a factor, in the last month, that is, April 2022, the direct contribution of “food” to overall inflation was close to 48 per cent; the contribution of “fuel and light” was less than 10 per cent. So, we have reason to believe that there is a domestic factor at work in the current inflation. Before we come to an investigation of this, we address the policy response thus far.
This month, in an out-of-turn meeting, the RBI’s Monetary Policy Committee raised the interest rate—the “repo”—by 40 percentage points. Here the Reserve Bank of India (RBI) has followed the standard practice of Western central banks. We are sceptical of its likely success in the context of the current inflation in India. What interest rate hikes do is to lower the rate of growth of the economy. In the US, where wages have been growing quite fast due to the unprecedented stimulus, this may slow inflation by slowing wage growth as employment growth slows. In India, slowing food inflation via monetary policy, which is what a rise in the interest rates amounts to, would be a more difficult task. Households may not lower their consumption of food as their income growth slows. This is related to the particular characteristic of food, that it is essential for survival. Households may however reduce consumption of other goods but, unlike in the market for food, the prices of industrial goods are not likely to drop quickly as demand falls.
When it does work as an anti-inflationary instrument, monetary policy accomplishes the task by slowing growth. Western central banks are not apologetic about this, averring that accelerating inflation reflects an overheating economy, one in which aggregate demand is too high, leading actual output of the economy to be at a level greater than what is warranted by market forces, termed the “natural level” of output. Now the output loss due to a restrictive monetary policy is rationalised as merely trimming excess output that was excited by too low a market rate of interest. The RBI holds the same view on inflation as do its Western counterparts. However, this is at odds with experience. The acceleration of inflation in India commenced in 2019 when growth was slowing. It may, however, be argued that there was some growth after all, and output had grown beyond the natural level of output.
Nikhil Kumar Mondal, 65, a retired school headmaster, buys vegetables from a vendor at a market on the outskirts of Kolkata on May 20. In India inflation tends to be led by rise in food prices, which has a cascading effect on prices elsewhere in the economy. | Photo Credit: RUPAK DE CHOWDHURI/REUTERS
This cannot be said of the 2020-21 period, when, struck by COVID-19, the economy actually contracted for the first time in decades. During that period, inflation not only did not budge downwards but actually accelerated mildly. Now, the only way the RBI’s diagnosis of inflation can be retrieved would be by arguing that the natural level of output declined by more than actual output. As the natural level of output is unobservable, a high degree of credulousness would be needed to go along with this assertion. Viewed alongside contemporaneous data on variables that are observable, such as the unemployment rate, the diagnosis that inflation is accelerating because the economy is overheating is difficult to swallow. For instance, in the quarter that followed the lockdown of March 2020, the urban unemployment rate rose over four times, suggesting anything but an overheating economy. In the very next quarter, the inflation rate accelerated, and remained elevated for most of that year.
It goes without saying that to control an economic phenomenon, we need to understand what underlies it. This holds equally for inflation. We have already indicated what drives inflation in India. Rising agricultural prices, of foodstuffs in particular, are the driving force. (We established this in an article in the journal of the Indian Econometric Society, the “Journal of Quantitative Economics”, July 2021.) Now, inflation control in India will have to approach the problem suitably. Monetary policy working via changes in the interest rate is a blunt instrument for the kind of inflation we invariably experience in India. There is persistent food price inflation, only varying in degree over time, because there is a continuing imbalance between the supply and demand for food, with the latter inevitably the greater, except in the case of cereals.
In such a scenario, suppose monetary policy were to cure inflation via demand contraction: Unless an improvement were to be brought about on the supply side, whereby food supply can henceforth be increased at a constant price, inflation is bound to revive when growth revives, and demand expands. We would have returned to square one.
It should not be too difficult to see where we are headed in terms of a proposed solution to inflation. If inflation over the long term reflects an insufficiently elastic supply of food, that is, one that cannot respond to increase in demand by raising output fairly quickly, then there is no alternative to acting on the supply side. We have an outstanding example of having significantly altered the supply side of Indian agriculture in the mid-1960s. The Green Revolution ensured that we have never been short of food since. Indeed, until recently, the government was actively exporting wheat to countries in need, a humanitarian act but one that can be inflationary. But we have never bothered to produce food at a steady price. In fact, the policy of continuously raising minimum support prices is inherently inflationary. What is needed is a policy that encourages the growth of yield in agriculture. With rising yield, farmers would be better off even if prices were to decline a bit.
Chronic food inflation in India gets no attention in the economic policy. After the economic reforms of 1991, the rationale of policy shifted, giving a greater role to the private sector. This is not by itself a bad thing. But along with the shift came a neglect of the things that only the government can do—bringing about a rise in agricultural yields being one of them. Imperceptibly, there was a shift towards the tenets of the Washington Consensus, which encourages focus on macroeconomic stability over all else. Low inflation was identified as a crucial aspect of macroeconomic stability, and it was designed to be achieved exclusively by an independent central bank. In 2016 the Modi government gave this view statutory status by amending the Reserve Bank of India Act of 1934.
Note that India is one of the few major economies of the world where food is expensive and yet there is continuous food inflation. Food is deemed expensive when a high share of household expenditure is devoted to it. This aspect is swept under the carpet by outsourcing inflation control to the RBI. The public distribution system does address the consumption of cereals, but procuring food at rising minimum support prices has a cascading effect on prices elsewhere in the economy. Think of the economic policy of the Modi government so far. After focussing almost entirely on the non-agricultural sector for about seven years, it announced the Farm Laws. But the Farm Laws were all about raising farmers’ income; it said nothing about the high and rising price of food, which has a long history in India. So, the food inflation we are facing should not come as a surprise at all. It reflects a weak agricultural sector. A weak agricultural sector is not unusual for a developing economy that is starting out, but its economic policy is then usually positioned to address the issue squarely. We have not seen a major economic policy initiative since 2014 that is geared towards raising agricultural productivity and containing inflation. In today’s India, unlike in the 1960s when the same party ruled at the Centre and in the States, the Centre’s role in bringing about a productivity transformation in agriculture is limited.
The embrace of the Washington Consensus by successive governments has had its consequences. It has meant that policymakers here no longer focus on the problems of India’s economy but are guided by some externally given metrics, such as a fiscal deficit target or the climate for foreign investors. Though low inflation did have pride of place in its “to do” list, the Washington Consensus position on inflation was that it reflects an overheating economy, which an independent central bank can control via monetary policy. As we have shown, the acceleration of inflation in India and its persistence even as the economy contracted during the COVID-19 years, suggests that this view is flawed. Until about a decade ago, the RBI was a repository of ideas and information on India’s economy. It appears to have since suffered from regulatory capture, allowing itself to be co-opted to serve a particular school of thought in macroeconomics.
Commenting on the acceleration of inflation across the globe presently, the Economist of April 23 refers to the research finding of some prominent Western economists to say that it is moot whether the current inflation will necessarily lower global growth. We can, however, think of a way in which it can in India.
With wages not indexed in much of the country’s economy, inflation—especially of the price of food—erodes real purchasing power. This can lower aggregate demand and thus output growth. In fact, the lowering of the trend rate of growth of the Indian economy from 2011-12 was preceded by unusually high inflation, including food-price inflation, which lasted for a few years. But the consequence of inflation should not be evaluated only in terms of its impact on growth. Its immediate consequence in an economy such as India’s is on well-being. With a section of our children suffering from malnutrition and women from anaemia, food-price inflation directly impacts lives. Interviews from rural north India point to already lowered food consumption among the poorest due to the present inflation. Food-price inflation, then, is a developmental issue. Its control cannot be assured by the RBI’s technology, not even when it is sold as a “modern monetary policy framework” by the government. In India, inflation requires broader economic management that addresses production conditions in agriculture.
Pulapre Balakrishnan is with Ashoka University, Sonipat, Haryana, and M. Parameswaran is with the Centre for Development Studies, Thiruvananthapuram.
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