7.5 per cent inflation: does it mean sleepless nights?

Inflation has touched 7.5%, what does it mean?

Means wholesale prices (prices at which your suppliers buy) increased 7.5 percent over their level last year. This is measured on a weekly basis and there is a two-week lag in the availability of numbers. So the current figure corresponds to the week ending July 24, 2004 and it indicates the increase in prices over the corresponding week in July 2003.

Does this include all prices?

The Wholesale Price Index (WPI) on which inflation is calculated includes three main categories: “primary articles (food and non-food articles)”, “fuel, power, light and lubricants, and “manufactured products”. The WPI does NOT include the price of services or house rent. It’s only a commodity price index.

So does an increase in inflation mean cost of living is rising?

The cost of living is measured by the Consumer Price Index for different groups of consumers such as industrial workers, urban non-manual employees and agricultural workers. The index measures prices of the typical consumption basket of each of these groups. Since the typical consumption basket includes services and rent, these items, which impact the cost of living, are included in CPI-based inflation numbers.

The latest data for the cost of living indices are available for May 2004. These figures were still below 3 percent, when WPI based inflation had already crossed 4.5 percent. Since commodities in WPI also enter CPI, it is expected that the cost of living would also show an increase for June and July. However, the number may remain below 5 percent.

Is 7.5% inflation good news or bad news?

Some inflation is good but not so much. 7.5% is high enough to disrupt production and consumption plans. A positive but low level of inflation is considered good for the economy as it allows relative prices of goods to adjust to changing economic conditions, demand, tastes and technology. For example, when people like a new product, its demand increases, prices of the product show a rise indicating to more producers to produce it. This allows production to adjust to taste. If prices were not allowed to rise, this could not happen.

So why does inflation rise?

Inflation figures are often reported in a somewhat statistical way. The price rise is attributed to its components. It may, for example, be said that prices rose in the sub-groups fuel, manufacturing, edible oils etc. This only points to the groups in which prices rose most. This method does not explain inflation. It tends to appear that the phenomenon was merely a concentrated rise in prices in a few items. This kind of an explanation is correct only when there is a price shock to one or two items such as oil prices which leads to a one-time change in prices. It does not explain the broad based tendency for prices across sectors to keep rising week after week.

How can the latest rise in inflation be explained?

Economists would typically explain inflation as a consequence of macroeconomic factors. These could be, for example, exchange rate movements, fiscal policies or monetary policies.

Recent weeks have seen the rupee depreciate. This means that foreign goods have become more expensive. Intermediates for industry and products like edible oil are now more expensive.

At the same time, monetary and fiscal policy have both been expansionary, contributing the pressure on prices.

Petroleum has seen the double effect of higher world prices and a weaker rupee.

In recent weeks all these factors have come together, pushing inflation rates up in India.

The Chief Economic Advisor said that the monsoon and good economic policy would soon bring inflation under control. What did he mean?

With the recent rains, it is expected that the monsoon would ease the supply of primary products and reduce the pressure on prices. At the same time if the government can tighten fiscal and monetary policy, it would help in the control of inflation. This, however, will not be easy. While the finance minister has declared his intentions of cutting deficits, as he is obliged to under the FRBM, he may not find it easy to do so if his optimistic revenue projections are not met. Similarly, it is doubtful that RBI will step in to raise interest rates to control inflation as the US Federal Reserve and the Bank of England have done.

Should we worry about the rise in inflation?

If you are a borrower, paying a fixed interest rate on a home loan for example, you should be happy at the higher inflation, because in real terms you pay less. In addition, if you don’t have a fixed income and your business actually gains from higher prices, you have a double whammy.

If you earn a fixed salary, say as a consultant, where your salary is not indexed to inflation, you can now buy less. The worst hit will be the retired, whose incomes do not adjust to price rise. If they are dependent on interest income, their real income will fall. All others who have lent money, e.g put money in bank deposits, will be also losers.

Only when interest rates rise, as is expected with higher inflationary expectations, the income of senior citizens dependent only on interest incomes will rise. Other salaried sections will also see a fall in what they can buy, till their DAs which are linked to inflation rates, catch up.

Why did bond markets go down with the news about inflation?

A rise in inflation was an indicator of a rise in interest rates in the future. It was a trigger for bond markets, who had been expecting interest rates to start moving up. Higher interest rates translate into lower bond prices. The entities holding bonds sold them while the going was good and as a result bond prices fell.

Does the US also witness inflation rates like 7.5 %?

Not for the last 20 years. The seventies saw “stagflation” in the US—high inflation and high unemployment. The highest was in 1975 at 19 percent. Since then macroeconomic policies managed to cure the problem.

Some countries like Argentina have seen runaway inflation rates of over 40 percent. Should we worry that something like that may happen in India?

It is unlikely. First, monetary and fiscal policies in India may be expansionary, but things are under control. Money supply is unlikely to go out of hand. The government is prevented from borrowing indefinitely from the RBI. In the current Indian context of an open economy, expansionary monetary policy is a byproduct of RBI’s exchange rate policy. On the fiscal front, the recent FRBM Act has put conditions on government deficits. This will manage to keep fiscal policy under control.

Most importantly, India is unlikely to get into a wage-price-spiral like Latin American countries because all wages are not indexed to prices. As a result, every increase in prices does not translate into an increase in the cost of production. The phenomenon of increase in prices, leading to an increase in wages, leading to an increase in prices, and on and on, until hell breaks loose, will not happen.

What is the inflation rate at which we can sleep peacefully?

At 2 to 3 percent. At that rate, inflation is gentle and benign. Yet, it is positive enough to allow price adjustment.

Ila Patnaik