Thursday, August 25, 2011

Changing Inflation dynamics in India

An excellent recent speech (via Mostly Economics) by the Executive Director of RBI, Deepak Mohanty, reveals certain interesting trends in India's inflation dynamics. A few points from the speech

1. The role of food inflation

He finds a structural break in the mid-2000s in India's WPI-based inflation, which is the measure of the policy headline inflation. The historical average long-term inflation rate of around 7.5%, which moderated in the first half of 2000s to about 5.2%, started rising in the second half to touch an average of 5.5%. More worryingly, the volatility in WPI inflation increased sharply.

The driving force behind this rise was primary food inflation, in particular protein items. He says,

"Protein inflation has assumed a structural character and is partly driven by demand factors. Within the protein group, persistence was lower for pulses as well as 'egg, meat and fish', but it was markedly higher for milk... Increase in demand for protein appears to be an inevitable consequence of rising affluence. This process was further accentuated by renewed global food price shock during 2010-11. Among the processed food items, the persistence of inflation for edible oils was high."

2. Core inflation

The inflation in non-food manufactured products, which represents the core-inflation, and which has a weight of 55% in the WPI, too has inched upwards since 2009-10. It averaged 4% in the 2000s, and even moderated in the second half of the decade, only to start rising from 2009-10. Deepak Mohanty claims that "the non-food manufactured products inflation shows a major structural break towards the middle of 2009-10 around the time the global commodity prices rebounded".

In fact, he even finds that industrial raw material prices also showed a structural break in early 2009 and the average price increase has been high and volatile.

The coincidence of the recent rise in core-inflation and the similar rise in industrial raw material costs, with the global commodities price increases, lends credence to the view that both are interconnected. He writes that the "pass-through from non-food international commodity prices to domestic raw material prices has increased particularly in the recent years reflecting growing interconnectedness of domestic and global commodity markets".

3. Demand side factors

The less discussed side of our inflation story is the rise in the purchasing power and resultant demand-side pressures, an inevitable consequence of the last decade of high growth. In fact, the the NSSO surveys (61st round and 66th round) shows that the nominal wage rates of skilled workers in both rural and urban areas increased much faster in the second half of the 2000s than in the first half. While the real wage rates declined in the first half, it increased significantly in the second half of 2000s. The wages of the rural unskilled labour has increased sharply, both in nominal and real terms, since the beginning of 2010.

As indicated earlier, a clear manifestation of this trend is the sharp spike in the consumption share of protein items in the rural and urban consumption baskets. The increase in wage rates of the unskilled rural labourers has certainly played a role in contributing to this spike in protein consumption.

In the formal sector, company finance data suggest that the wage bill has risen at a faster rate since the middle of 2009-10.

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