Wages of inflation

Indian Express, 17 September 2010

Yesterday, RBI hiked interest rates and the government hiked the dearness allowance for central government employees by 10 per cent in response to higher inflation. While most other countries in world are witnessing low and falling levels of inflation, inflation in India has risen in recent months.

Other than food prices, most of the prices in the Wholesale Price Index(WPI), both the old index based on 1993-94 weights, and the new index, are determined in international markets. Other than through changes in the exchange rate of the rupee, policy makers in India can do little about controlling price rise in these. Nor surprisingly, when policy makers focus on the Wholesale Price Index as the index to try to control, they feel helpless. No one wants to be held accountable for controling WPI inflation. Statements are made about how it is caused by a drought, or international commodity price movements, or the rising demand in China or rain in Brazil.

What should be done differently so that policy in India can effectively control inflation? One element in the puzzle is to identify the inflation rate that matters to people, one that policy can impact upon and controlling which would have the greatest impact. The WPI does not fit this role. First, the WPI is not meant to represent the consumption basket of the average (urban or rural) citizen. For instance, about one fourth of WPI represents food, while the average basket contains about 50 to 60 percent food. The Consumer Price Index(CPI) is a better candidate for telling us about what is happening to the purchasing power of the aam admi.

Further, even if the WPI rises by 6 percent, but if the CPI rises by 10 percent, the government would have to raise dearness allowance by 10 percent. Changes in the consumer price index represent movements in the purchasing power of the rupee. At present, there are many consumer price indices in India but since they mostly move together, there is no conflict in which one is chosen. The Consumer Price Index for Industrial Workers has the most recent weights, and while it is not perfect and there is much scope for improvement, it is a reasonably good measure. It impact peoples welfare.

Another important question is whether policy, in particular monetary policy, can do anything to impact prices as measured by this index. One, often heard argument, is that since half of the CPI consists of food items, there is nothing that can be done about CPI. This argument needs to be reversed. Since nearly half of the CPI is non-tradables such as services, in constrast to the WPI, these are items whose prices are determined in India, rather than in world markets. Indeed, if domestic policy action can have impact, it is more likely to have impact on the CPI rather than on the WPI. Prices of non-tradables, goods and services that cannot be traded internationally, are determined in the domestic economy.

Salaries and wages, whether in the formal or in the informal sector are likely to be linked to the cost of living. By being a better representative of the cost of living, the CPI feeds into wages. Higher expected cost of living often means that wages rise. As a consequence, in the following year, there will be a higher cost of production which will result in higher prices. This "wage-price spiral" can go on. What might have started as food price inflation can spill over into non-food prices.

Recent trends in India show that this is already happening. The issues on food prices are highly complex and, in the short run again, policy makers feel helpless. As long as various distortions exist in food and agricultural markets and institutions, there is a sense of doom when faced with higher prices. So does this mean that there is no way to prevent the spill over from food inflation to wage inflation, that the economy will inevitably face higher inflation? This question has been a bigger issue in countries in Europe or Latin America where the bulk of the labour force works in the formal sector. Wages in the formal sector are negotiated economy wide and the spillover from consumer prices to wages is very strong. In India this is less of a problem as the bulk of the labour force works in the informal sector and countrywide powerful trade unions negotiating wages for the year ahead do not exist to that extent. Yet, while of a smaller dimension, the problem is not absent.

Many countries have addressed this issue by setting up institutional mechanisms to curb expectations about inflation. So even when a country can do nothing about the international price of oil, or food demand in China, if it is able to tell its citizens that it will do whatever it takes to curb inflation, then compared to countries that do not say so, it is able to curb inflationary expectations. These prevent high cost push through wage increases and the consequent spillovers. The commitment to deliver low and stable inflation has to be credible and is often accompanied by institutional mechanisms such as a commitment on low fiscal deficits and a mandate to the central bank to "target inflation". Each of these countries chooses the appropriate inflation index to focus upon, and the mechanisms for making the central bank accountable for it.

Recent developments in India suggest that it is time for the goverment to devise such a framework. A framework that delivers low and stable inflation is pro-growth and can increase the welfare of the aam admi as well as provide a favourable business environment.

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