The onion's layers

Indian Express, 13 January 2011

The government is grappling with the problem of inflation. The solution to persistent, moderate is not straight forward. It needs a multi-pronged approach. Agricultural reform and stabilising macroeconomic policy need to be two important elements of this strategy.

Today's problem is onion prices. Last month the discussion on inflation focussed on dal and meat. A while ago, it centered on sugar prices. Each time we face high food prices, traders and speculators are blamed and income tax raids are conducted. Sometimes exports are banned. At other times, imports are permitted. Often, forward trading in the product is banned. Either a drought or excess rain are said to be the source of inflation. Rising incomes leading to higher demand, and supply bottlenecks in an unreformed agriculture, are seen to be ultimately responsible.

The debate on the agricultural reform agenda that seeks to address supply bottlenecks has been about improvements in cold storage chains, changes in the mandi system, reform of the agricultural marketing system, research support for high value crops, liberalization of trade in agricultural products, opening up the sector to organised retailing and FDI, moving away from price support for cereals, and so forth. Over the last 5-6 years, as the problems in food prices have surfaced again and again, we have discussed the solutions endlessly. However, very little has been done on the reform agenda. And when prices increase sharply, instead of commitment to reform, we hear statements by the government on how it plans to clamp down on speculators and stop hoarding or ban derivatives trading.

The present food inflation could become another episode where the government takes a few visible and meaningless steps to show that it is solving the problem, and then essentially heaves a sigh of relief when prices come down. Instead it should move forward on the reform agenda. To the extent that the reform agenda is politically difficult, it will be difficult. Also, since there are few short term gains, as many of the changes would take a few years to yield results, the government has to resist the temptation to put its focus on fire-fighting, and to steadfastly implement a long term agenda of reform. Political support for the reform agenda is likely to limited, as opposition parties tend to focus on undermining the government to make political capital. But without reform the problem of food inflation will surface again and again. Curbing speculation is not a viable alternative to reforming the sector.

The second element of government policy to address the inflation issue must focus on stablilizing macroeconomic policy. Fiscal expansion, it appears, might have overshot the needs of the economy. The fiscal deficit of the central government increased sharply from 3.1 percent of GDP in 2007-08 to 7.5 percent of GDP in 2008-09. This was due to increased expenditure such as the sixth pay commission, higher subsidies, and lower taxes during the global financial crisis. However, the stimulus continued in the following year, and it remained at 6.8 percent of GDP in 2009-10. In the current year, the fiscal deficit of the central government is projected to be at 6.6 percent of GDP. The total deficit of the centre and the states combined also rose sharply during the crisis. Before the crisis it stood at 4.4 percent of GDP in 2007-08 and in the current year it is projected to be 9.6 percent of GDP. The fine tuning of the stimulus to the needs of the economy is not an easy job. However, stabilising macroeconomic policy requires that the government should undertake fiscal consolidation. This would pull down aggregate demand and curb some of the demand side push to food prices.

Another element of stabilising macroeconomic policy needs to be contractionary monetary policy. Here the question is should monetary policy respond to rising food inflation? Interest rates are normally seen as an instrument that will hurt investment, but have no effect on food supply, which is where there problems are supposed to lie. This argument is used to say that monetary policy need not respond to food inflation. The issue to examine is whether food price inflation feeds into the general level of inflation. If spending on food is a large share of the consumption expenditure basket, as it is in India, for real wages to stay constant, nominal wages must rise significantly. Higher nominal wages can result either in lower profits or higher selling prices. In services, which are often more labour intensive, especially in the informal sector, which consitutes the bulk of the Indian economy, it is often easy to perceive. But, it is exactly here that data is hard to come by. Annecdotal evidence does suggest that higher food prices result in the workers in the informal sector getting paid higher nominal wages.

The relationship between food prices and interest rates is not strainght-forward. The simplistic logic that tries to draw a direct link between interest rates and food prices misses out the role of food prices on inflationary expectations and in wage negotiations. Even though wage bargaining in India is not like in Latin America where indexation played a major role in causing inflation, in India too the dearness allowance of public sector workers, or trade union negotiations on the basis of which wages are fixed, refer to inflation in consumer prices. Indeed, even the NREGA wage is now being indexed to inflation to prevent NREGA real wages from falling. Rising food prices and wages feed into expectations of higher inflation. The role of monetary policy is to indicate that it will raise rates to curb the growth in aggregate demand so that the shock to food prices does not translate into a wage-price spiral.

No one step will be able to bring inflation under control. The government must adopt a multi-pronged strategy to inflation. Agricultural reform must go hand in hand with contractionary fiscal and monetary policy.

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