Economy Insights

Persistent inflation makes rate hike imperative

Fuel

Food

Ma nuf act

uri ng

ON FLATI IN

Rate hike

Analytical contact Dharmakirti Joshi - Chief Economist Vidya Mahambare - Senior Economist Dipti Saletore - Economist

October 2011

Persistent inflation makes rate hike imperative

By CRISIL Centre for Economic Research (C-CER)

C-CER Team Dharmakirti Joshi Vidya Mahambare Dipti Saletore Chief Economist Senior Economist Economist

Persistent inflation makes rate hike imperative

Key Points
The persistent nature of inflation, we believe, makes another repo rate hike imperative if inflation is to be brought down to around 5 per cent and maintained at around that level. As of September 2011, inflation, as measured by changes in the wholesale price index, has stayed above 9 per cent for the past 20 months1; above 8 per cent for 28 months and above the RBIs comfort zone of 5 per cent, for 48 out of 66 months since April 2006. While monetary policy can lower inflation and its expectations, the short term trade-off between growth and inflation will continue to rise, unless the supply potential of the economy is raised and wages and income transfers are linked to productivity. Persistent and stubborn inflation India in recent years is largely due to near simultaneous occurrence of shocks, many of which are linked to the fiscal policy, and have tended to be permanent in nature.

Policy coordination is critical for achieving low inflation

The Reserve Bank of India (RBI) is responsible for maintaining low and stable inflation. It does so by bringing down demand for goods and services, in line with supply. Fiscal policy can support the objective of low inflation, either by expanding supply potential and/or by not creating excessive upward pressure on demand. However, an expansionary fiscal policy which contradicts the monetary policy actions by raising overall demand without sufficiently increasing supply potential of the economy defeats the objective of inflation control. This phenomenon has been experienced in India in recent years. Sustained fiscal push in terms of a near simultaneous increase in wages and income transfers across most income groups, and not linked to productivity, has kept demand persistently surging ahead of supply. This has constantly raised inflation and inflation expectations, leading to higher demand for wages, in turn bringing persistence to inflation. In this situation, monetary policy cannot maintain low and stable inflation, without a sledgehammer of high interest rates and credit squeeze, to bring down demand sharply. To lower inflation and maintain high growth rates, government policy must simultaneously work towards expanding the supply potential of the economy, which could complement the central banks efforts to contain excess demand and inflation.

Inflation and inflationary expectations have become persistent

Inflation, as measured by the annual change in the wholesale price index, is not just high, but has become more persistent in nature in the past 5 years. Inflation has, since April 2006, remained higher than Reserve Bank of Indias comfort level of inflation at about 5 per cent. In the 66 months beginning April 2006 to September 2011, WPI inflation has remained -

o o o o

above 5 per cent in 48 months, above 6 per cent in 44 months, above 7 per cent in 34 months and above 8 per cent in 28 months
1

In fact, inflation has remained for above 9 per cent in the last 20 months1. Even core inflation (non-food manufacturing inflation, which indicates demand side pressures) has remained at or above 5 per cent in 5 out of last 7 years (See Table 1), much above RBIs threshold level. This has in turn fuelled expectations that inflation will remain high going forward.

CRISIL Research therefore believes that given this recent trend, for inflation to permanently move to around 5 per cent, it will not only have to fall, but will also have to stay low for a considerable period of time. Without sustained low inflation, inflationary expectations cannot be anchored. For this, monetary policy must continue with its tightening stance at least until core inflation consistently starts showing signs of moderation.

Table 1: Inflation above 5 per cent is not a new phenomenon

FY01 7.1 0.4 28.4 4.7 FY02 3.6 2 9.3 2.2 FY03 3.4 3 5.5 2.2 FY04 5.5 4.1 6.4 5 FY05 6.5 3.5 10.1 13.6 6.5 2.6 6.6 5.7 0.1 5 11.7 5.7 -1.7 0.2 12.3 6.1 12.9 7.4 FY06 4.4 5.4 FY07 6.6 9.6 FY08 4.7 7.1 FY09 8.1 9.1 FY10 3.9 15.2 FY11 9.6 15.8 FY12 9.6 8.9

Overall Food Fuel group Core

Note: Green indicates inflation 4%, Orange indicates inflation between 4% and 5%, Red indicates inflation 5%. Source: Ministry of Industry, CRISIL Research

Expectations about future inflation influence household decisions about how much they consume today versus how much they hope to consume in the future. If households expect inflation to go up, there is an incentive to buy now before prices begin to rise faster. Similarly, inflation expectations also influence how companies set prices and how wages are negotiated. If people believe high inflation is here to stay, they would demand higher wages. This in turn raises demand in the economy, leading to a wage-price spiral. Firms are willing to pay higher wages, since they believe they can pass on higher wage costs to consumers in the form of higher prices.

Figure 1: Average Inflation and growth forecast for the next five years
WP I CP I GD P 8.5 8.0

7.0

6.3 5.5 5.0

Q1 2008-09

Q3 2008-09

Q1 2009-10

Q3 2009-10

Q1 2010-11

Q3 2010-11

Q1 2011-12

Source: Professional forecasters survey, RBI

Except in November 2010 when it was recorded at 8.2 per cent.

The RBIs Professional Forecasters Survey suggests that participants have upwardly revised their mediumterm (next 5 years) outlook on WPI inflation, consistently since the third quarter of 2008-09. The latest forecast results released in August 2011 place medium-term inflation outlook at 6.3 per cent. (Figure 1).

The nature of recent shocks to inflation

In India, persistence in inflation and inflationary expectations has been spurred by a near-simultaneous occurrence of five shocks, many of which have tended to be permanent in nature (See Table 2).

Table 2: Shocks hitting Indian economy in the second half of 2000s Shock Nature of the shock

Regular increases in administered food grain prices in conjunction with declining agriculture productivity Elevated levels of International oil price Sustained shortfall of skilled labour A rise in rural wage floor linked to wages under MNREGA, which are now indexed to inflation Pay revisions of public sector employees
Source: CRISIL Research

Permanent supply shock Near permanent supply shock Permanent supply shock Permanent demand shock Temporary demand shock, but effects can linger

Persistently high inflation influenced by permanent and structural factors typically result in people revising their expectations about future inflation. If spikes in inflation are influenced by temporary factors, the inflation impact fades away as the shock recedes. In contrast, the permanent factors elevate the trend level of inflation, unless counteracted by a combination of fiscal and monetary policy tightening.

Whether monetary policy reacts to shocks demand or supply - depends on the potential duration of the shock. If a demand shock is temporary for example, for a one time increase in excise tax rate, then monetary policy need not react. Despite short-term consequences of higher prices and subdued demand, the impact on inflation will fade away after a year, all else remaining the same. However, if a demand shock is relatively permanent, in which it raises demand for relatively longer period of time, then the monetary policy needs to react in order to curb inflation.

In recent years, a permanent demand shock in the form of the expansion of the Mahatma Gandhi National Rural Employment Guarantee Act (MNREGA) across rural regions, with wages indexed to inflation has been at work. This has raised the floor for rural wages and raised incomes in rural India, in both formal and informal sectors. These in conjunction with a hike in public sector wages which have nearly doubled the nominal incomes of public sector employees in just a couple of years, have raised disposable incomes across India nearly simultaneously. With nominal incomes rising fast (Figure 3 and 5), demand in the economy has been elevated and remains healthy.

Likewise, if a supply shock is more permanent in nature, inflation begins to rise on a sustained basis. These shocks have taken form of an increase in cost of production due to a sustained shortfall in say, supply of skilled labour which raises its price, a continuous increase in international crude oil prices, or regular increases in minimum support price (MSP) (Figure 2). During FY06 to FY12, MSPs of foodgrains, in
3

particular, have risen by an average of 11.7 per cent compared to a 5.7 per cent during FY00 to FY05. This has consistently raised the floor for the market price of these commodities and has contributed to the stickiness in food inflation. A failure to raise agricultural supply potential has further aggravated the situation. (Figures 3). Similarly, the shortfall of skilled labour (Annexure 1) has increased skill premium and has tended to sharply raise their wages.
Low agriculture output growth coupled with rising minimum support price pushes up inflation
Figure 2: Minimum Support Price hikes
2004-05 2011-12 230 193 190 204
1 50.0

Figure 3: Agri Price and Output Movements

248
200.0 P rice Output

1 00.0
2004-05=100

Paddy

Jowar, Bajra Maize

Ragi

Arhur (Tur)

Moong

50.0 2004-05 2005-06 2006-07 2007-08 2008-09 2009-1 0 201 1 0-1

Note: (2004-05=100) Source: Ministry of Agriculture, CRISIL Research

Note: (2004-05=100) Source: CSO, Ministry of Industry, CRISIL Research

Upward momentum in international crude oil prices has also taken the shape of a near-permanent shock to inflation due to its sticky nature. Barring the global recession in 2009, crude oil prices have consistently exerted higher cost pressures on the corporate sector. While it is necessary to pass on international oil price increases to domestic consumers, the ad-hoc nature of increases in administered fuel prices raises the element of unanticipated inflation, thus interrupting the impact of monetary policy decisions.

In recent months, a transitory risk to inflation has emerged in terms of depreciating rupee. Despite some softening of global crude oil prices in recent months, a depreciating rupee is pushing up import costs, thus raising inflation in domestic fuel prices, which are linked to international prices. However, the second-round pass-through of exchange rate depreciation into retail prices would be limited as firms would find it difficult to raise prices because of slowing private consumption growth.

Policy co-ordination
While the interaction between demand and supply determines the level of prices, the role of monetary policy is restricted to influencing the level of demand in the economy. The expansion of supply potential is determined by the quantity and quality of factors of production, namely labour and capital, and to a large extent, influenced by government policies. In addition, fiscal policy also influences demand pressure via both direct government spending and changes to household income through changes in public sector wages and minimum income guarantee. Government policies related to education and enhancement of skills, and capital spending determine the availability and cost of labour as well as infrastructure. Monetary policy will face the perennial pressure to trade off economic growth for controlling inflation in the near future, if the fiscal policy is not supportive to the objective of inflation control.
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Annexure 1: Strong nominal income growth across various income groups made inflation persistent
Wages across income groups
Wages per day, Rs 2005 2010

365

232

122 89 93 93 69 Urban casual private+public Rural Regular 134

194

59 MNREGA Public works other than MNREGA

49 Rural casual - private

Urban Regular

Results from FICCI Survey

Yes No Extent o f wage increase % o f respo ndents

Is yo ur o rganisatio n facing labo ur sho rtage

90%

1 6%

82%

A re yo u seeing an increase in wage rates due to labo ur sho rtage labo r?

90% 0% 20% 40% 60% 80% 1 00%

0%

50%

1 00%

Less than 5% wage increase B etween 5% to 1 wage increase 0% M o re than 1 wage increase 0% L th 5% i

Public sector wages per person (excluding appear payments in 2008-09 and 2009-10)
267 Rs.'000 244

1 87

1 38 1 07 15 1 1 21

84

95

97

2000-01

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

2009-1 0

201 1 0-1

Source: NSSO, FICCI Survey on Labour Shortage / Skill Shortage for Industry - August-September 2011, Ministry of Finance, CRISIL Research

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