Wednesday, August 12, 2009

Monetary policy and inflation

In a recent speech, the Governor of the Reserve Bank of India (RBI) made a few interesting observations on monetary policy in India. In the background of the ongoing financial market meltdown induced global economic crisis, he questioned the gold standard of "inflation-targeting" driven model of central banking and favored a broader mandate that sought to maintain price, financial market and macroeconomic stability so as to promote economic growth.

He pointed to the large fiscal deficits, persistence of administered interest rates and narrow and illiquid private debt market in India as coming in the way of effective transmission of monetary policy signals made to target inflation.

In a reference to the confusion surrounding the importance and even relevance of the multiplicity of wholesale and consumer price indices to measure inflation in the country, he raised doubts about the possibility of any "single representative inflation rate for an emerging market economy with market imperfections, diverse geography and 1.1 billion people".

Of more importance now was the Governor's reservations on whether the RBI could do much to "tame a supply driven inflation except as a line of defence in an extreme situation". Even as the WPI based headline inflation index (with its comparison of week-to-week from last year) hovers in the negative territory, food prices have been spiraling upwards, thereby discouraging the RBI from easing monetary policy any further despite strong pressure to do so. There have been reports that the RBI is even considering increasing rates in response to inflationary pressures arising from higher food prices.

Though food prices have been on a sharply increasing trend across the country, there are considerable differences between the price variations on food grains, pulses, sugar and vegetables.

In an excellent FE op-ed piece, Madan Sabanvis attributes the rise in food grain prices to increases in Minimum Support Prices (MSP) (30% increase for paddy and 8% for wheat), shifting consumer preferences from coarse cereals to rice and wheat, and rise in procurement by FCI (stocks of rice and wheat have crossed 50 mt). He also traces the volatility in pulse prices to seasonal variations, absence of buffer stocks, and lack of imports, and vegetable prices to delayed monsoon and higher transport prices due to fuel price hikes in June. The increase in sugar prices is discussed in an earlier post here.

The Financial Express traces the increase in prices for vegetables like potatoes, tomatoes, and onions to a sharp drop in vegetable arrivals in the Delhi wholesale markets (mandis). This supply crunch is attributed to the massive procurements by organized retail chains who source a large share of their requirements directly at the mandis. These large retailers leverage their scale of operations and retail vegetables at lower prices than even the mandis. The restrictions imposed on direct procurement from farmers, the absence of sorage and other upstream linkages in the vegetable production chain, and the absence of a national market in them have genreated nuerous other distortions in the market for these products.

Apart from these, the poor monsoon and expectations of higher prices in the coming months, amplified by speculative hoarding, have also contributed to the upward pressure on food prices. The multiplicy of aforementioned factors, mostly involving supply-side constraints and none of them related to credit side issues, lends credence to the RBI Governor's scepticism about the utility of monetary policy in addressing inflation borne out of price rises in food items. In the circumstances, there is little that the RBI and monetary policy responses can do to modulate the volatility in food prices and the inflation that reflects it.

More immediate-term solutions would involve maintaining buffer stocks in commodities other than wheat and rice and carrying out open-market operations in them to modulate supply-demand mismatches. It is also necessary to address policy and regulatory issues like market distortions arising from politically motivated MSPs, restrictions on the free movement of commodities across states etc.

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