Inflation as measured by the WPI (Wholesale Price Index) is trending at 9% levels and is expected to trend higher on the back of fuel price hikes by the government. The government, in June, raised prices of diesel, LPG and kerosene to pass on the rise in global crude oil prices to the end user. The fuel price hike is expected to add 0.6% to inflation and there are expectations of inflation for the month of June coming in at double-digit levels. Policy makers from the finance minister to the RBI governor are all in inflation control mode. RBI has raised policy rates by 75bps over the last couple of months while the government is curbing it’s borrow and spend policy to bring down inflation expectations.
Policy makers are at a risk of losing focus on the future while looking at the past. Inflation is something that has already happened. Inflation numbers come in with a lag of a fortnight. Inflation is measured on a year on year basis where the current index levels are compared to last year’s index levels to determine the extent of price rise. Inflation trending at 9% or 10% levels means that over last year’s levels prices have risen by 9% or 10%. It does not mean that prices will rise 9% or 10% next year from present levels.
Policy makers should ask themselves whether prices in the economy would rise by 9% from present levels over a one year time period. Policy makers should have asked the same question to themselves when fiscal and monetary policy was loose, and inflation picked up momentum on the back of high liquidity, low policy rates and fiscal recklessness. They did not and inflation is at close to double-digit levels.
Policy makers are not asking themselves if inflation will rise from current levels and if so by what percent. Forecasting is not easy and policy makers have gone completely wrong in their forecasts, but given policy measures already taken and given the current economic environment, there can be a fair degree of accuracy in trying to predict price rises.
What is the outlook for economic growth? GDP forecasts will not reveal the true picture as GDP is expected to grow by 8% or 8.5% this year. Anecdotal evidence and sound bytes emanating from the corporate sector is not at all bullish. Infrastructure companies are seeing slowdown in investments. Corporate sector from real estate to auto is seeing demand slowdown. Financial services sector is feeling the pinch of weak capital markets. Banks are lowering credit growth forecasts. On the global front, government spending in the US and Eurozone have come off due to budget deficits. Unemployment in the US is at 9% levels while in some Eurozone countries such as Spain, Greece and Ireland unemployment is rising due to austerity measures. Consumer demand is not likely to rise on a sustained basis in these countries. China is consciously tightening policy to bring down rising inflation expectations. China’s growth is forecast to come off from double-digit levels to levels of around 8%. China growth coming off dampens commodity prices, as China is the largest consumer of commodities.
Clearly, India and the world are in a sluggish economic environment and in this environment it is difficult to see where price rise will come from.
Monetary policy is tight with the RBI having raised policy rates by 275bps over the last fifteen months. Liquidity in the system has been tight for over a year now, with banks borrowing from the RBI on a daily basis to meet daily liquidity requirements. The government has brought down its fiscal deficit from 6.8% of GDP to 5.1% of GDP (2008 to 2010). The government deficit target is 4.6% of GDP for this year. Government finances are weak with the government having to borrow from the RBI to meet its spending requirements and given current state of liquidity (tight) and bond yields (at multiyear highs), the government cannot borrow and spend. Monetary and fiscal policy is working on demand. Demand slowdown is inflation negative and price rise will not happen because of demand.
The future does not look too bright for inflation and policy makers should look at the future rather than the past for taking inflation based policy decisions.