Reining in Inflation in India: Options for a Developing Economy

Case Code: ECON036
Case Length: 30 Pages
Period: 2005-2011
Pub Date: 2012
Teaching Note: Not Available

Price: Rs.400
Organization : -
Industry : -
Countries : India
Themes: Macro Economics Evaluation

"The price buoyancy has persisted since 2008-09. In fact, the level of inflation observed in the economy has been a matter of great concern. Fast increasing food prices are denting family budgets across the country, especially of people in the low-income brackets."

-Commission for Agricultural Costs and Prices, in 2011.

"We are not sure whether we have all the tools in our hands to control food inflation."

-P. Chidambaram, home minister (former finance minister), Government of India, in 2011.

"I get less perturbed by inflation; I would be [perturbed] if it goes beyond 15%. Obviously, hyper inflation will impact growth, but we are nowhere near that."

-Prof. Arvind Panagariya, the Jagdish Bhagwati professor of Indian political economy at Columbia University, in 2011.

Introduction

India, an economy which consistently posted a GDP growth rate of over 8% since 2005, was battling high inflation in mid-2011. Only during 2008-2009 was the GDP growth rate less than 8% in the face of an acute global recession. Headline inflation (measured in India through the Wholesale Price Index (WPI)), which includes both food and non-food primary articles besides manufactured items, was above 8% during the whole calendar year of 2010. It was constantly above 9% from December 2010 to June 2011. In July 2011, it stood at 9.22%, more than two times the RBI's threshold level6 of 4-6%7 and was expected to stay high in the short- to mid-term.

With inflation hovering at over 9%, the Reserve Bank of India (RBI), India's central bank, followed a tight monetary policy regime. Between March 2010 and January 2012, RBI hiked interest rates 13 times consecutively to limit liquidity in the economy and curb demand and thereby control the growing inflation. Consequently, the repo rate stood at 8% in July 2011, up from 4.75% before March 2010. Though, the demand in interest rate sensitive sectors such as automobiles and consumer electronics moderated, the demand for food and non-food primary articles still remained high. Economists, while expecting another rate increase from RBI by the end of October 2011, maintained that monetary tightening alone might not be enough to control inflation and that government should complement RBI's rate hikes with tight fiscal policies.

Spiralling Food Inflation: Getting out of Control?

The Indian economy was characterized by relatively high inflation prior to the introduction of economic reforms in 1990-91. During the post reform era, however, inflation grew more moderate once the reforms percolated deeper into the economy. Average inflation, which was 9.6% during the 5-year period between 1991-92 and 1996-97, slipped to 4.6% in the next five years, before slightly increasing to 5.3% between 2003-04 and 2007-08. Inflation which was under control for almost a decade, and even went below zero for a brief period in mid-2009, started increasing at a quick pace from mid 2008-2009.

It spiralled, "reflecting both supply and demand pressures. Supply pressures stemmed from elevated domestic food prices and rising global prices of oil and other commodities. The source of demand pressures was an economy with low per capita income which recovered sharply from the crisis. The supply pressures and demand pressures collided, triggering a wider inflationary process," according to D. Subbarao, Governor of RBI. A severe drought in 2009 was considered to be the chief reason for the inflation, along with post-crisis monetary and fiscal policies characterized by various fiscal stimulus measures which resulted in easy credit. The monsoon rainfall in 2009 was 679.3 millimetres against the normal rainfall of 884.1 millimetres or 23% below normal, -- the worst in 37 years. With the drought, food supplies fell. The growth rate of agriculture and allied sectors declined by 0.15% (negative growth) in 2008-2009, and recorded a growth of 0.44% the following year. On the other hand, lenient monetary and fiscal policies ensured abundant liquidity in the economy. Sustained demand due to policy measures during and post crisis, coupled with supply constraints in food produce resulted in food inflation. The Commission for Agricultural Costs and Prices,13 in its report on the price policy for the 2011-2012 kharif season, identified that inflation in primary articles, particularly food articles, was the main contributor to inflation in the economy....

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