Sunday, June 8, 2008

It is not "embedded inflation"

This blog has consistently argued here and here that the RBI has a limited role to play in the current inflation scenario. The global rise in commodity prices and the resultant cost-push nature of inflation means that monetary policy levers become irrelevant.

Yes, oil is kicking on to $140 and maybe beyond, but RBI can do little to either lower oil price or to keep people from consuming oil. The major driver of inflation has been commodity and foodgrain prices, which are not sticky and adjust quickly to supply side signals. In contrast, the cost of final goods like consumer durables, services, and wages have not shown any alarming rises.

In this context, this blogpost by Paul Krugman makes interesting reading. He makes the distinction between those products and services whose prices fluctuate in response to market signals and those which are stickier and whose prices are set at fairly longer intervals. He defines inflation arising form the later as embedded inflation, since there is the possibility of a competitive price setting spiral among producers, that causes inflationary expectations to get embedded into the system. Such inflations can be addressed with Central Bank intervention.

But in case of the former, as we have in India today, the only option for Government is to mitigate the hardships faced by the poorest by strengthening the social safety nets. Such times are a strong reminder of the continuing need for a vibrant and strong food security and targetted social security policy. And direct cash tranfers are an excellent way to efficiently target the beneficiaries.

Update 1
Pauyl Krugman has this explanation of the importance of core inflation - in measuring "inflation inertia".

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