Monday, August 04, 2008

Why 13% inflation is a possibility

India Infoline News Service
Inflation is headed higher and may fall only after touching 13%. The headline inflation is likely to stay in double digits till the end of 2008 and may average out at 10% during the financial year 2008-9. By March 2009, inflation could still be in the 6-7% range, higher than the RBI`s target of 5.5%.

If you are worried about the wholesale price index (WPI) inflation hitting a 13-year high of 11.63% (for the week ending June 21), there's more bad news in store. Inflation is headed higher and may fall only after touching 13%. The headline inflation is likely to stay in double digits till the end of 2008 and may average out at 10% during the financial year 2008-9. By March 2009, inflation could still be in the 6-7% range, higher than the RBI's target of 5.5%.

There are several reasons why inflation is likely to be higher. The recent hike in fuel prices added about 1% to inflation. But this hike pushes up other goods' prices, adding another 1% to the WPI inflation indirectly. Secondly, with global oil prices ruling strong at around $140 a barrel, the prices of goods across sectors such as petrochemicals, plastics, textiles and paper, where petroleum products form part of the inputs, will also go up.

Besides, the prices of oil and industrial commodities such as metals show up in the prices of domestic manufactured goods after a lag of 3-6 months. So, even if the global commodity prices start falling from tomorrow, their impact on domestic prices will be felt only towards the end of 2008.

The weakening of rupee compared with the dollar and other major currencies is also increasing pressure on domestic prices. While domestic conditions normally determine the pricing power of companies, a strong domestic demand, capacity constraints and a surge in global commodity prices are allowing domestic manufacturers to follow the import-parity pricing. So, the domestic inflation has become acutely sensitive to global commodity prices and rupee value.

This is more true of the WPI, which has a large proportion of industrial commodities. While this means that the WPI inflation could remain higher than the consumer price index (CPI) inflation, which is currently in the 7.8-9.1% range, the CPI inflation will catch up and also hit double digits over a period of time.

Inflation outlook

The wholesale price inflation is likely to stay in double digits till the end of 2008. The average for 2008-9 may be 10%

Interest rate outlook The RBI may further hike repo rate and CRR by 0.5% each. The interest rates may go up by 1% or more

Tackling inflation Banning exports and cutting import duties won't help. The best way to tame inflation is to increase the interest rates. This would curb demand

Rupee exchange rate A stronger rupee can help control domestic inflation, but the government does not want to hurt exports

Global commodity prices
If global commodity prices fall, inflation may come down. But the full effect on prices shows only after a lag of 3-6 months

What is the government doing to tackle inflation? Here we need to remember that inflation is a global problem in the face of the sharp rise in commodity prices, and each country's response is tailored to its own macro-environment. In the Indian context, the environment of a strong domestic demand, comfortable forex reserve position and stable financial sector is conducive to decisive actions to tackle inflation.

However, the steps taken by the government, such as banning exports or cutting import duties, have failed to serve the purpose. This development discredits the supply side or the cost-push theories. The same theories were peddled in the US three decades ago in the aftermath of the 1973 oil shock. However, government intervention could not reverse the inflationary pressures and the US Federal Reserve had to resort to massive hikes in interest rates to break the back of inflationary expectations.

While it is true that inflation is a global phenomenon, claiming that it boils down to international supply issues is an invalid argument. In India, the record growth performance over the past five years has set the stage for inflation to accelerate to double-digit levels. A belated recognition of this fact as well as the limitations imposed by the state of government's finances have forced the government to take a backseat and allow the RBI to handle the problem.

The central bank has responded by hiking its key policy rate the repo rate by 0.75% in June and the cash reserve ratio (CRR) by a cumulative 1.25% since the beginning of April. These measures were meant to suck out excess money from the banking system and raise the cost of funds for banks. The banks responded by hiking both the lending and deposit rates. Before the end of 2008, I expect the RBI to further hike the repo rate and CRR by 0.5% each. Over the coming months, all categories of borrowers corporates, households, traders will find the cost of their borrowings go up by 1% or more.

This is a painful, but right step. Over a period of time, higher interest rates will have the desired effect on demand for goods and services and curb the pricing power of domestic firms. More pertinently, these actions will send a signal to the companies and workers that the RBI will not tolerate high inflation and accordingly decide their pricesetting and wage-setting behaviour.

Assuming that the global supply situation does not deteriorate further, these steps should start bearing fruit by early next year. As a corollary, domestic growth should cool off from the current unsustainable levels, but India will still continue to be one of the fastest growing economies in the world.

The decisive actions by the RBI and the anticipated drop in inflation will have a salutary effect on the Indian economy over the long term. A central bank that gains control over inflation and expectations of future inflation will be able to deliver a stable macro-economic environment that will set the stage for an extended period of high growth.

In India's case, it is imperative for the RBI to deliver such results as the record of fiscal policy in contributing to growth is weak. After a few years of improvement, the government's finances could worsen this year, adding to the pressure on interest rates.

Of course, there is another way to tackle inflation by allowing the rupee to strengthen against the dollar and other currencies. While the decline in Indian companies' share prices has had a negative impact on the rupee, it is also true that the RBI and the government do not fancy the currency option. A stronger rupee will push down domestic prices but will hurt exporters when they compete in foreign markets. So in order to protect the margins of exporters, monetary measures will necessarily mean higher interest rates possibly higher than those warranted to curb inflation.

So far, so good. Is there any flipside to the above arguments? In the coming months, domestic inflation may abate if global commodity prices, especially crude oil prices, fall from the current levels. Such a development could persuade the RBI to not raise interest rates. While I do not subscribe to this view, such a fall in commodity prices cannot be ruled out. So if you are worried about inflation, keep an eye on the global oil prices and do your bit for energy conservation.

Reproduced From Money Today. © 2008. LMIL. All rights reserved.

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