columnist is a senior economist at the macro modelling and
forecasting division of the National Council of Applied
Economic Research (NCAER). Since completing her doctorate at
the University of Surrey she has been tracking developments in
the Indian economy. She is editor of the "MacroTrack", NCAER's
quarterly update on the economy. |
Wonders will never cease to happen. Inflation at
a two year high is making headlines but, surprise, surprise;
it is causing very little concern. The usual fuss is totally
absent. Why? Largely because inflationary expectations are
It's like this - what you, me and every Tom Dick
and Harry believes will be the inflation rate in the future
impacts the current inflation rate. It's quite simple, if you
expect that the price of Onions will go up next week, you rush
down to the market and buy some today. On the way back home
you tell you neighbour about this and not wanting to be left
behind he rushes to the market as well. Pretty soon everybody
is rushing to the market to buy Onions and the price of Onions
goes up today because everybody is expecting it to go up next
week. And this can become an inflationary spiral in which
prices continue to rise only because everybody believes that
prices shall go up in the future.
Your next question
is likely to be, is there any way to track inflationary
expectations that does not involve going down to the local
market place and observing the goings on in the market? Sure
there is. The best indicator of inflationary expectations is
the level of interest rates. Ordinarily, when inflationary
expectations are high, there is likely to be an upward
pressure on interest rates. For the simple reason that
interest rates move in sync with inflation. High
inflation-High interest rates and Low Inflation-Low interest
rates - that's the norm.
In fact even if the inflation
rate is not impacted by higher inflationary expectations, as
is very often the case in India, the interest rate is impacted
because people are willing to save only if they expect the
purchasing power of their money to grow at some positive rate.
So if inflationary expectations are very high it pushes up
nominal interest rates (the published interest rates) so that
the real interest rate (nominal rate-inflation rate) on
savings is positive.
Consensus is for lower rates
But right now, despite high inflation rates,
there is a general view that interest rates are too high and
ought to be lowered. It is this, more than anything else,
which suggests that inflationary expectations are low. Of
course, there is always a divergence between savers and
investors. Naturally, savers demand higher rates. Equally
naturally, borrowers of capital bay for a lower cost of
capital. But, regardless of this, interest rates are nearly
the same -- or even lower -- compared to the last two years
when, in fact, inflation was much lower.
Inflation is being driven by fuel costs
The low inflationary expectations are mainly
because the current spurt in prices has been fuelled by the
sudden and sharp increase in international oil prices, which
in turn, led to increases in domestic prices of petroleum
products. Inflation, as measured by the wholesale price index
(WPI) has risen to over 8%. This is because Fuel and energy
costs, which have a weight of less than 15 percent in the WPI
have risen by over 30 percent over last year's prices.
But now that the increase in oil prices is under
control, it is believed that inflation is no longer an
imminent danger. Of course, the recent decision by OPEC to cut
oil production may push oil prices up again. But, hopefully,
they will remain under $28 per barrel.
The two other
product groups in the WPI, primary commodities, manufacturing
have a combined weight of over 85 percent -- and they have
risen only by 3-4 percent. This also implies that it is not an
economy-wide phenomenon resulting either from excess demand
(more people rushing to the market) or excess money supply
(more money in everybody's wallet) but is due to a specific
increase in a volatile commodity (Oil).
So it is also useful to look at what is called
"core inflation". This is measured by the rates of change in
WPI minus the rates of change prices that may be very
volatile, or by taking out the prices that are administered by
the government. In the US, some economists choose to subtract
the prices of food and fuel.
In India, a possible
measure of core inflation was first discussed during the onion
price increase in 1998. The sharp increase in onion prices
pushed up the WPI more than that the Consumer Price Index
(CPI) because the food and primary products group had a higher
weight in the CPI. The general point then, too, was that price
increase was not generalised or economy wide. Though the
political consequences were dramatic.
...is the measure that should influence policy
Apart from the political aspects, core inflation
has a serious economic implication as well. This arises from
the fact that if inflation is economy wide, it implies a need
for checking demand (stop people from rushing to the market)
and tightening money supply (reduce the amount of money in
their wallets). To contain demand the government can cut
expenditure, raise taxes and reduce fiscal deficits. Money
supply can be tightened by raising the cash reserve ratio,
raising interest rates or by cutting central bank lending to
the government (which amounts to nothing but printing currency
notes to satisfy the government's needs).
But the only
way to find out if the inflation is generalised or confined to
some product groups -- onions or oil, it doesn't matter --
fiscal and monetary policy makers need to monitor core, rather
than headline, inflation.
Ignore headline inflation
One of the main factors responsible for the
current slowdown in Indian industry has been identified as a
slowdown in demand. A low core inflation rate supports the
view that the risks of an expansionary fiscal and/or monetary
policy pushing up inflation are limited. In other words, the
economy may be able to support a higher fiscal deficit and a
higher money supply or a cut in interest rates as they may
push growth without pushing up the inflation rate.
Expansionary fiscal policy may be what we need As the
government and RBI try to balance pressures from different
sections of society interest rates may or may not be cut. But
it is possible that despite the higher current inflation rate,
the economy can afford a somewhat more expansionary fiscal
policy (tax cuts, higher deficit) and monetary policy (lower
interest rates, lower cash reserve ratio etc.) in the coming
months without apprehensions of a general price increase.
For instance, on the fiscal front if the government
were to give a kick start to private investment and reduces
taxes (a good way of doing this may be to remove the surcharge
on corporate and individual income tax) it would be an called
and expansionary fiscal initiative as it would increase the
fiscal deficit but at this point in time such a thing can be
done because core inflation is low.
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