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THE INFLATION WAR BEGINSVidya Bala, The Hindu Business Line, 31 July, 2011

Lack of investment in the manufacturing space, besides the spill -over effect from primary products, has pushed inflation to alarming levels.

The RBI's unexpected 50 basis-point hike in repo rate to 8 per cent shocked themarkets. But, then, the central bank may not have had any other option to counter inflation; the 10 rate hikes till June and two bumper crops have done little to curbprices. From an inflationary situation that was driven primarily by food prices, we nowhave a situation of a more broad-based inflation, as acknowledged by the RBI itself.

Even as the inflation worry raged across Asia , most countries in the region, barringIndia, have managed to curb pricing pressures reasonably well. So what has led tothis persistent pressure in India that has pushed the RBI to a more aggressive

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monetary policy mode? And would this put an end to the rallying prices? Sadly, thereare reasons to believe that the inflation scare may not fade any time soon.

Too long for comfort

Let us first look at the length and magnitude of the inflation problem. While theaverage inflation was 5.5 per cent between 2006 and 2009, we have now had awhopping 19 months of over 6 per cent growth in the Wholesale Price Index (WPI)on a year-on-year basis.

Seventeen of these months saw inflation in the 9 -10 per cent range. Clearly, the timeperiod over which the current high level of inflation has lasted is above norma l and alittle disconcerting.

Moving to the constituents of the WPI basket, primary products (of which foodaccounts for a good 70 per cent) index has been expanding in double -digits for 22months now. While the drought in 2009 was believed to have driven grain and fodder prices to steep levels, that primary products inflation never returned to single -digit,post the bumper summer and winter crops in 2010, does little to explain the still -elevated levels of primary article prices.

Contrary to belief that the recent administered price hikes in fuel would aggravateinflation, this index has been on a high for quite a while. The fuel index, has been ona double-digit trajectory for 17 months now, far ahead of the average of 4 per centbetween 2006 and 2009. T he last, but most important component of the basket,manufactured products, may have been slow to register an increase, but their effectappears to be the most lethal of them all. With a 65 per cent weight in the WPI, a riseof a couple of percentage point s in this index can cause damage. To understand theimpact that manufactured non-food products (called core inflation) can have on theheadline numbers, consider the following:

Way back in January 2010, headline inflation was 8.7 per cent, when food infla tionwas a frightening 19.8 per cent and core inflation at a sedate 3.7 per cent. Now, withthe food inflation down to 8.3 per cent; core inflation, at 7.3 per cent, has been thekey trigger to push headline numbers higher to 9.4 per cent.

Why core inflation matters

The accompanying chart indicates that the WPI surge between December 2010 andJune 2011 has been steeper than earlier periods as a result of core inflationcontributing more to the inflation pie. While food and fuel inflation are known to bevolatile it was the core inflation numbers that kept headline inflation under check or reined it back to comfortable levels on earlier occasions.

This was also made possible by the surge in investment as a proportion of GDP upto 2007-08. The supply from added capacities kept prices of manufactured productsunder check.

However, this time around, the RBI itself has expressed concerns over a soft patchin gross fixed capital formation (GFCF), visible from the second half of 2010 -11. For instance, GFCF expanded by 19.2 per cent in the last quarter of FY-10 compared

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with a sluggish 0.4 per cent in the March 2011 quarter; this number being lower thanany other March quarter since 2008.

C hallenges ahead

Clearly, the spill-over effect of primary products inflation on manufactured goods,accentuated by lack of investment in the manufacturing space has pushed inflationto levels not easily reversible. The above sticky phenomenon of inflation clearlysuggests that the RBI's baby steps of 25 basis point rate hike eigh t times betweenMarch 2010 and March 2011 did not help much.

With a steep 50 basis points in May 2011, on realising that demand -pull issues werefuelling inflation more than was anticipated, followed by another 50 basis point hikenow, will the RBI be successful in curbing the more raging issue of demand? Easier said than done for the following reasons:

A moderation in manufactured non-food product inflation would be possible only if there is a softening of input costs and easing of demand. Let us take the first case.While commodity prices have shown signs of easing, fuel, a key input in mostindustries, would only now kick-start its journey upward.

While the direct impact of the recent administered fuel price hike on the WPI is only0.7 per cent, the indirect impact, through user industries, could be much higher. Two,while electricity price inflation has remained moderate, it may be only a matter of time before the price increases in coal and mineral oils are felt in electricity prices.

Three, while it has to be acknowledged that demand has moderated as seen in autosales, industrial production and purchasing managers index (PMI), it needs to bekept in mind that surging exports and non-oil import growth may not slow enough,especially the former, given the tight capacity globally. Fiscal risks arising from

mounting subsidies too pose a threat to investments, keeping interest at elevatedlevels.

If these are the challenges to curb demand, the food problem is no better. Even as anormal monsoon can be expected to soften food prices, the recent hike in minimumsupport prices (MSP) in some of the agri-commodities can set the index rollingnorthward again, as MSPs typically set the floor for market prices.

Shortage of labour and steep hike in labour costs may also offset the price benefitsof an otherwise good bounty. Permanent solutions to the food problem lie inaddressing issues such as poor irrigation facilities, low yields, lack of proper storageand transportation facilities. These gather importance, more than ever, with

consumption gaining ground.