Posted by: qmaxim | August 10, 2019

Is higher inflation bad? Not really

Newspapers and TV channels routinely report on inflation numbers whether they have gone up or down and to what extent. And what the government/ RBI (Reserve Bank of India) is doing about it if it has shot up?  If inflation index shows a spike, there is a panic in government circles. Inflation has remained steady over the last few years and is in fact falling. But, is low inflation good? Not necessarily.

During the 1st term of Narendra Modi led government, in consultation with then RBI governor Dr Rajan, a law was passed whereby main focus (rather only focus) of monetary policy and government was to maintain retail inflation in the 2-6% band. And to progressively reduce deficit to around 3.5%.
Entire focus of the monetary policy was so called ‘inflation targeting’. I.E. progressively reduce inflation year on year primarily by keeping interest rates high. No mention was made of increasing GDP growth rate or job creation.

What really happened
When PM Modi took over the reins of power in 2014 from Manmohan Singh led UPA government economy was in mess. Inflation was running in double digits, growth had started stalling, corruption scandals were order of the day and it was widely held view that it was a directionless administration. So, main focus of the new govt. was to bring order and reduce inflation to start with. Govt. managed to these pretty quickly. However, this  has  continued as main plank of the policy even after 5 years.

Why lowering inflation may not be good
Inflation index called CPI (consumer price index) is a composite number derived from of prices of basket of various items, & their respective weightage based on their relative importance. There are mainly two inflation numbers published at periodic intervals, headline and core inflation. Inflation targeting strategy supposedly targets headline inflation.
India being a large country — prices vary a great deal from place to place. Prices depend on many factors – distance from production centres, transportation costs, income levels at the location, applicable taxes, number of middlemen, etc. Income level varies great deal through out the country. For example, apples produced in north of the country sells for Rs 50/kg at Delhi wholesale market and consumer in Bangalore typically pays Rs 120/kg. Obviously, the difference is  due to transportation costs, numerous middlemen, losses due rotting, etc and has nothing to do with  interest rate set by RBI.
The inflation index gives great deal of importance to food items which may not be important anymore, for most people for two reasons. For city folks with higher income, food items form small part of their expenses. Low income families are provided highly subsidized food grains and some other items, hence does not matter for them either. In many cases price paid by poor is absurdly low – for example rice which sells for Rs 35/kg typically is supplied at Rs 1/kg.
However, low prices of food items hits farmers hard as their buying power greatly depends on it. As farmers and rural folks constitute more than 50% population this effects demand for most items such as — FMCG items, tractors , electronics, two wheelers. This effects growth of entire Indian economy. In spite of government fixing higher and higher reserve prices at which it buys food grains from farmers, prices have remained at low levels. In fact in most cases, food grain prices have remained stubbornly below reserve prices fixed by the government. While inflation has started falling and has remained low, worryingly for the government GDP growth has started falling in the recent quarters.

Does the RBI have control over retail inflation?
It does not appear to be so. RBI sets lending rates depending on inflation index, higher the expected inflation, higher is the lending rate to banks. This is called Repo rate which is 5.4% currently.
RBI’s own studies have indicated weak or no correlation between repo rate and inflation index. In fact during last fiscal, actual inflation numbers were consistently and significantly lower then RBI predictions. However, increasing lending rate makes borrowing costlier for wide range of goods and services such as housing and electronics.

For these reasons, a new framework is needed. Emphasis of new framework should be on growth and employment generation NOT on ‘inflation targeting’. How inflation index is calculated requires a re-visit as well.
See my coming blog on how to revive growth ….

I will be pleased to hear your views

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