inflation insight_oct 2011
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8/3/2019 Inflation Insight_Oct 2011
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October 2011
Analytical contact
Dharmakirti Joshi - Chief Economist
Vidya Mahambare - Senior Economist
Dipti Saletore - Economist
Economy Insights
u M a n u f a c t r i n g
I N F LA T I O N INFLATION
F o o d
e Fu l
R a t e
h i k e
Persistent inflation makes rate hike imperative
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Persistent inflation makes rate hike imperativeBy CRISIL Centre for Economic Research (C-CER)
C-CER Team
Dharmakirti Joshi Chief Economist
Vidya Mahambare Senior Economist
Dipti Saletore Economist
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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 RBI’s 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 bank’s 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 India’s comfort level of inflation at about 5 per cent. In the 66 months beginning April 2006 to
September 2011, WPI inflation has remained -
o above 5 per cent in 48 months,
o above 6 per cent in 44 months,
o above 7 per cent in 34 months and
o above 8 per cent in 28 months
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• 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 RBI’s 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 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12
Overall7.1 3.6 3.4 5.5 6.5
4.4 6.6 4.7 8.1 3.9 9.6 9.6
Food0.4 2 3 4.1 3.5
5.4 9.6 7.1 9.1 15.2 15.8 8.9
Fuelgroup
28.4 9.3 5.5 6.4 10.113.6 6.6 0.1 11.7 -1.7 12.3 12.9
Core4.7 2.2 2.2 5 6.5
2.6 5.7 5 5.7 0.2 6.1 7.4
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
5.0
6.3
5.5
7.0
8.0
8.5
Q12008-09 Q3 2008-09 Q12009-10 Q3 2009-10 Q12010-11 Q3 2010 -11 Q12011-12
WP I CP I GDP
Source: Professional forecasters’ survey, RBI
1Except in November 2010 when it was recorded at 8.2 per cent.
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• The RBI’s Professional Forecasters’ Survey suggests that participants have upwardly revised their medium-
term (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 inconjunction with declining agriculture productivity Permanent supply shock
Elevated levels of International oil price Near permanent supply shock
Sustained shortfall of skilled labour Permanent supply shock
A rise in rural wage floor linked to wages under MNREGA,which are now indexed to inflation
Permanent demand shock
Pay revisions of public sector employees Temporary demand shock, but effectscan linger
Source: CRISIL Research
• 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. Theseshocks 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
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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 Figure 3: Agri Price and Output Movements
193 190
204
230
248
Paddy Jowar, Bajra
Maize
Ragi Arhur (Tur) Moong
2004-05=100
2004-05 2011-12
50.0
100.0
150.0
200.0
2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11
Price Output
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
59 4969
134
194
89 93 93122
232
365
MNREGA Public works other than
MNREGA
R ural casual - priv ate U rban c asual -
private+public
Rural Regular Urban Regular
Wages per day, Rs
2005 2010
Results from FICCI Survey
90%
90%
0% 50% 100%
Are you seeingan increase in
wage rates due
to labour
shortage
labor?
Is your
organisation
facing labour
shortage
Yes NoExtent of wage increase
% of respondents
16% 82%
0% 20% 40% 60% 80% 100%
Less t han 5% wage increase
Between 5% to 10% wage increase
M ore than 10% wage increase
Public sector wages per person (excluding appear payments in 2008-09 and 2009-10)
8495 97
107115 121
138
187
244
267
2000-01 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11
Rs.'000
Source: NSSO, FICCI Survey on Labour Shortage / Skill Shortage for Industry - August-September 2011, Ministry of Finance, CRISIL Research
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