Inflation eats into our networth and investments value while it also impacts the growth of the nation's economy. Let's try to understand inflation and how it impacts the economy as well as measures to control inflation. (Another link on understanding inflation: structural or temporary)

Inflation is caused by a mismatch of demand and supply, particularly demand overshooting supply. During periods of rapid growth and structural change, as India is currently undergoing, inflation does tend to increase. Let's start with the current situation.

The Current Situation: Inflation was 9.8 per cent in August 2011 and 9.7 per cent in September and in October 2011. During this period food inflation first declined from 9.6 per cent in August to 9.2 per cent in September and then rose to 11.1 per cent in October. WPI Inflation has been high since January 2010.Headline inflation was 10.9 per cent in April 2010 and was showing signs of coming down when it touched 8.2 per cent in November 2010. Unfortunately, it rose again and has remained over 9 per cent from December 2010 with the October 2011 inflation rate being 9.7 per cent. However, food inflation, which was nearly 22 per cent in February 2010 declined to under 8 per cent in June 2011 and was 11.1 per cent in October 2011 and as of November 5, 2011 was 10.6 per cent.

Since August 2011, overall WPI inflation has been stable.  However, there was appreciable decline in non-food primary inflation from 18.2 per cent in August to 7.7 per cent in October. The inflation in manufactured goods also declined from 7.9 per cent to 7.7 per cent.

In these three months, certain food items namely, fruits and vegetables, egg, meat, fish and milk have been the major contributors to food inflation. Along with fuel and power items, which exhibited a rising inflation in October, it has led to the stickiness in headline inflation. Within food items the average inflation in cereals has been 4.7 per cent in the period August to October 2011, with negative inflation in wheat. The inflation in pulses was also negative 4.3 per cent in August  and 2.8 per cent in September 2011.

Global Developments

In a globalised world, where the growing Indian economy is dependent on commodity imports in critical areas like fuel oils, edible oils and other primary imports, movements in international prices have a direct bearing on level of domestic inflation and its management. The post-global financial crisis conduct of macroeconomic policy in the developed world has also created problems for inflation management in the developing countries.

In a bid to jump-start their economies and cut down unemployment, several countries have expanded liquidity in their markets. The US Federal Reserve went in for a second round of quantitative easing, as it released 600 billion dollars into the American economy. Similar measures have been undertaken by UK, Japan and some other industrialised nations. In today’s globalised world one country’s liquidity easily flows into another country. This increased liquidity in the industrialised countries has generated inflationary pressure in virtually all emerging economies and some developing countries.

There is another peculiar development in the international markets that has contributed to inflationary trends being sustained over the past 12 months in import-dependent emerging markets. Despite weak prognosis of global growth and trade in the short to medium term, international commodity prices have not softened at the anticipated pace. For example, crude oil was around 75 USD a barrel in January 2010, but on an average continues to be around USD 110  in the current year.  Speculative activity in commodity markets and some supply disruptions in fuel oil (Libya) have kept the commodity markets tight.

The increased uncertainty in the Euro-zone on account of sovereign debt crisis has led to shifting of capital from Europe to USA which has hardened the US dollar against most currencies. The Indian Rupee which was Rs 44.4 to a dollar in April 2011 has depreciated to Rs 52 as of November 21, 2011. As a result whatever little benefit could have been derived from the softening of international commodity prices, has been wiped out by the depreciation in Rupee.

The Reserve Bank of India has been monitoring the foreign exchange markets closely and will take the required action in light of the international developments as the situation unfolds.

Domestic Demand-Supply Imbalances

The domestic demand supply factors that have contributed to the present state of inflation in India.     When there is a mismatch between demand and supply, it follows that there are two things to do - improve supply and moderate demand. But it is not always possible to increase supply to desired levels in the short-term. We can resort to imports or ban exports and take measures that will increase supply over time. On the demand side, while in principle it is possible to compress and restrict it through tighter fiscal  and monetary policy control, the risk is that if it is done rapidly then growth may decline sharply creating unemployment.

Sustained high economic growth in recent past has led to improvements in purchasing power in both rural and urban areas. The 12^th Plan Approach Paper says that average real wage rate between 2007 and 2010 has increased by 16 per cent at the all India level.  The supply response has been inadequate and along with weather induced shortages in the food economy, have resulted in significant challenges for inflation management.

Controlling Inflation:

A range of administrative, fiscal and monetary measures have been used to address the problem in the term. Among fiscal measures:

• Import duties reduced to zero on rice, wheat, pulses, onion, edible oils (crude), and to 7.5 per cent on refined and hydrogenated oils and vegetable oils;
• Maintained the Central Issue Price (CIP) for rice (at Rs 5.65 perkg for BPL and Rs 3 per kg for AAY) and wheat (at Rs 4.15 per kg for BPLand Rs 2 per kg for AAY) since 2002.
• Duty under Tariff Rate Quota for Skimmed Milk Powder (SMP) reduced from 15% to 5% for import upto an aggregate of 10000 metric tonnes in a financial year. National Dairy Development Board (NDDB) has been allowed to Import of 30,000 tonnes of Milk Powder and 15,000 MT of related products at zero per cent concessional duty for the year 2011-12.

In terms of administrative measures, at different points of time, the following steps were taken:

• The export of all varieties of onions was prohibited w.e.f 9th September, 2011. Later the prohibition on export of onions was withdrawn w.e.f 20^th September 2011 and export of all varieties of onions is now allowed.
• Import of raw sugar allowed at zero duty under open general licence (OGL).
• Maintained the Central Issue Price (CIP) for rice (at Rs 5.65 perkg for BPL and Rs 3 per kg for AAY) and wheat (at Rs 4.15 per kg for BPLand Rs 2 per kg for AAY) since 2002.
• Suspension of Futures trading in Rice, urad and Tur by the Forward Market Commission in the year 2007-08 continues during 2010-11.  Futures trading in sugar were suspended wef 27.5.2009 up to 30.9.2010. However the future trading in sugar has since been resumed, with effect from 27.12.2010.
• Banned export of edible oils (except coconut oil and forest based oil) and pulses (except Kabuli chana and organic pulses up to a maximum of 10000 tonnes per year).
• Stock limit orders extended in the case of pulses, paddy, and rice up to 30 September 2011 and edible oil and edible oilseeds up to 31 March 2011.
• Export of milk powders (including skimmed milk powder, whole milk powder, dairy whitener and infant milk food), Casein and Casein products has been prohibited with effect from 18.02.2011.
• An additional adhoc allocation of 50 lakh tonnes of foodgrains made on 16th May, 2011 to all State/UTs  for BPL families at BPL issue price for distribution during the current year up to March, 2012.
• An additional adhoc allocation of 25 lakh tonnes of foodgrains made on 6.1.2011 to all States/UTs for APL families @ Rs. 8.45 per kg for wheat and Rs. 11.85 per kg for rice for distribution upto 30.9.2011.
• Scheme for distribution of subsidized imported edible oil through state governments/ UTs with Subsidy of Rs/kg for distribution to ration card holdrrs @ 1 liter per ration card per month.

Special Scheme for distribution of subsidised imported pulses as well imported edible oils was initiated to address shortages in the availability of these commodities. The Government also held back the pass through of international prices of fuel oil (diesel, kerosene and LPG) up until June 2011 with a view to mitigate the impact of inflation on the consumers. As of now the under recoveries of PSU Oil Marketing companies for diesel is Rs 10.17 per litre, PDS Kerosene Rs 25.66 per lire and LPG Rs 260.50 per cycliner.

RBI's Role:

The Reserve Bank of India has tightened liquidity by raising the interest rate. The repo rate has been raised by 350 basis points during this time in a series of small steps from March 2010. It currently stands at 8.5 per cent.

The RBI takes into account the important concern of balancing the targets of controlling inflation and keeping up growth and employment generation.

The fiscal deficit as a percentage of GDP was 6.4 per cent in 2009-10. In 2010-11 this was brought down to 4.7 per cent. This year we have set ourselves a target of 4.6 per cent. This is a difficult target, given the deterioration in the global economy and its impact on India over the last 3 to 4 months. We have to be careful not to over-do ourselves in reaching this target since that can have an excessive slowing down impact on growth.

Policy Stance Going Forward

A durable solution to inflation in an economy with rising income levels lies in improving agricultural productivity, strengthening food supply chains and augmenting capacities in the manufacturing sector to keep pace with the growth in demand. It requires a facilitative policy environment and, where required, increased public investments, so that these measures can be actively pursued. Both the Central Government and the State Governments have a specific role to play.

PDS is an important vehicle to address price rise. In fact the moderate inflation in cereals has been facilitated by improved PDS operations in some states. Accelerated PDS reforms are essential and States need to take the necessary initiative as we move towards a food security Act to insulate the poor and vulnerable from the impact of food inflation.

Expeditious action is being taken to create storage space for centrally procured foodgrains. As on 30.6.2011, 16.8 million tons (as against 15 million tons decided earlier) of capacity creation has been approved on the basis of storage gap. The total capacity sanctioned so far is 7.37 million tons. It is expected that 4 million tons of additional capacity will become available by the end of this financial year. The next round of sanctions is in progress.

Please Search Here for more stories of your interest. Thanks.

Subscribe to our feed and get updates in your email inbox Send your feedback and any questions to editor@personalfinance201.com. Thanks.