The decade of the Nineties has been amongst the most eventful as far as the Indian economy is concerned. A fundamental instrument of government policy disappeared with the dismantling of the system of industrial licensing, while other radical reforms altered the basic features of the Indian economy. Gross domestic product growth rates fluctuated, the Bombay sensitive index rose to dizzy heights in the mid-Nineties and then plummeted down after the collapse of the technology boom, and governments changed several times. But despite all these transformations and upheavals, the economy was characterized by a remarkable degree of price stability for much of this period. This was even more remarkable when one recalls that the Central government maintained a fairly high level of fiscal deficits during the decade, and much of this was monetized.
Unfortunately, the official wholesale price index shows that the rate of inflation has crossed 6 per cent towards the end of March — this is a two-year high. The truckers’ agitation in April resulted in a further increase in prices, so that the WPI figures for April look even worse. To the extent that the truckers’ movement was a temporary phenomenon, the inflation figures for April can be ignored. But the March WPI figures are a cause for serious concern.
When elections are imminent, a typical knee-jerk reaction of the Central government is to give priority to anti-inflationary policies, which are sometimes inimical to growth. There are hopeful signs that an industrial revival is round the corner, and anti-inflationary policies should not choke off possibilities of industrial growth. One can only hope that the government will respond in a rational manner, after serious analysis of the causes of the current inflationary pressures.
Of course, no one can really question the importance of controlling inflation. If inflationary pressures are not contained, then the rise in prices may disorganize production by distorting market signals. Exorbitant increases in the price level also hurt the fixed income group consisting of salaried employees, pensioners and daily wage earners since their money incomes always lag behind price increases. The plight of pensioners will be particularly severe — an overwhelming majority of them depend on interest incomes. Nominal interest rates have been pushed downwards over time in order to reduce the cost of borrowing of industrialists. This move has been justified in the past by appealing to the low levels of inflation which ensured that real rates of interest remained at moderate levels despite the fall in nominal rates. But the current rate of inflation implies that the real rate of interest is negligibly low.
What are the possible factors which can cause inflationary pressures' Prices can rise sharply when the economy is “overheated”. In somewhat simplistic terms, this happens when excess demand in the economy pushes up prices because supply falls short of demand. This phenomenon is likely to occur when an economy is growing very fast. In such situations, the textbook remedies to control inflation are to operate on the demand side of the economy, and adopt policies which curb demand. For instance, the government can increase taxes to reduce disposable incomes and hence aggregate demand. A more typical measure to curb aggregate demand is to restrict availability of credit, either by increasing rates of interest or more directly by imposing quantitative restrictions on the supply of credit. This forces entrepreneurs to postpone their investment decisions. So, aggregate demand falls and inflationary pressures are mitigated.
Such measures have an obvious downside — a fall in aggregate demand can restrict growth. Moreover, if inflationary pressures are not caused by excess demand, then such policies have no effect on price levels. Factors on the supply side may just as well trigger off “cost-push” inflation. For instance, a shortfall in production or supply of some crucial input may push up cost of production of some goods and then set off a chain reaction which leads to spiralling prices. As a matter of fact, a popular perception is that the increase in international oil prices during the build up to the war in Iraq has been the main factor behind the current round of inflation.
Fuel is an important component of the overall price index. Moreover, there was a rapid increase in the wholesale price of fuel throughout the last calendar year. So, the increase in oil prices has contributed to the overall rise in prices during the last three months. However, with the war in Iraq coming to an end rather quickly, oil prices seem to have stabilized, and so should not have any bearing on the inflationary situation in the immediate future. What is of greater concern is the steady rise in prices of primary articles. This group includes both food and non-food items such as oilseeds and cotton.
Not surprisingly, the rise in prices of food items has been relatively modest, although last year’s harvest was rather poor. This is because the government has been sitting on huge stocks of food grains, and must have been only too happy to release part of the excess stocks into the market. Unfortunately, the government does not have stocks of cotton or oilseeds, and the paltry production last year has caused prices to shoot up astronomically.
Although the government does not have any stocks of cotton or oilseeds, it has managed to accumulate a very comfortable reserve of foreign exchange. Thus, there is no reason why the government cannot import large quantities of crucial non-food items during the next few months. These imports will add to the domestic supply and thus have a dampening effect on prices — just as the release of food grains from Food Corporation of India warehouses has had on prices of rice and wheat. Of course, imports of items such as oilseeds and cotton can only be a temporary palliative. The situation will improve if the agricultural harvest this year is satisfactory.
If the nascent industrial revival does actually take place, then there will be some increase in aggregate demand. However, there is sufficient excess capacity in the economy to ensure that the increase in aggregate demand is matched by an increase in supply of goods. In the immediate future, effective supply side management in the form of judicious imports of non-food items and release of food grains from buffer stocks will ensure that inflationary forces do not run out of control.