The current ‘inflation’ is a mystery. FinMin, RBI must tread carefully | Business Standard Column

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At a time of declining incomes, people don’t have money. So they do not buy. If they don’t buy, prices must fall, not increase. What, then, explains the inflation? T C A Srinivasa Raghavan explores

T C A Srinivasa-Raghavan

Here’s something that someone cleverer than me will explain to me: how can there be inflation at a time of declining incomes? I mean, if people don’t have money they will not buy and if they don’t buy, prices must fall, not increase?

Milton Friedman, the great monetary economist, said inflation happens when money supply grows faster than the supply of goods and services. That certainly is happening globally, except perhaps in China, but who knows what really happens there.

However, Friedman also said that people spend now according to a sense they have of their lifetime earnings. This is called the Permanent Income Hypothesis which he tested and validated.

But it now seems fairly certain that people would have formed a very gloomy view of their lifetime earnings and would, therefore, be spending less and saving more.

So where is the excess demand coming from to push up the price level on a sustained basis? The short answer is that there is no excess demand, so it isn’t what economists call demand-pull inflation. That brings up the other cause of inflation — and mind that there are only two types — called cost push inflation.

Usually, cost-push inflation is caused by an increase in input prices like labour, materials and interest. But with factories laying off people, there is no increase in overall labour costs.

Likewise, with demand being depressed because of successive waves of the virus and the resulting lockdowns, material costs are also not going up. And, with the RBI following a very easy money policy along with capping interest rates chargeable by banks, there is no interest pressure either.

That leaves the price of imported inputs. But with so much of our industrial intermediates coming from China — which nearly always sells below cost — and a strong rupee, it is unlikely that there is cost-push from imported inputs.

That leaves fuel costs where a combination of high taxation and high international prices could be exerting pressure. But fuel has a very low weight on the inflation index and is unlikely to be responsible for anything significant.

So, why is the index going up? The consumer price index is now increasing at 7 per cent per year or thereabouts. The RBI’s target rate is 6 per cent per year.

Two explanations
There are only two possible answers to this question. One is that prices are not going up at the rate of 7 per cent per year. The higher spot prices we see in the market are just that — spot prices. The other is that prices are indeed increasing at 7 per cent per year, but only because the index is wrong.

Besides, last year at this time, there had been a general collapse in prices because of the severe lockdown. Optimists would like to believe the former theory, that the index is wrong. Pessimists would like to believe that it is accurate and that there is indeed a sustained upwards pressure on prices.

Eeny meeni miini moh

So which view should form the basis for policy? The answer depends on whether you are a bond market-wallah or the finance minister or the RBI governor. The bond market type, with a huge vested interest in low inflation, will believe the index and howl if it inches out steadily. A finance minister will not accept that the index could be flawed but still insist that prices are not rising even when the index says they are. And the RBI governor, caught between the two, will speak from both sides of the mouth till ordered by the government to use only one side.

The finance ministry and the government will therefore have to be very careful in what they do, how they do it, and when. To bowdlerise a very nice song, that’s the beauty of, that’s the glory of, inflation. It confuses.

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