Inflation and Policy Options

Arun Kumar

Inflation has become the biggest worry for the government. It is hurting the vast numbers of the poor the most but not sparing the middle classes either. This has social and political implications which ought to worry the ruling dispensation. The free supply of food and energy to the poor started during the pandemic does help but not enough. The poor also buy other things whose prices are rising since there is generalized inflation and that impacts their budgets.

What can the government do to control the situation? Wheat prices were rising rapidly so the government imposed a ban on its export (with some exceptions). The PM talked of cutting taxes on petroleum products but controversially shifted the blame to the State governments. The RBI in panic held an extra emergency meeting of the MPC and announced steps to reduce liquidity by raising CRR and to cool down demand moved to raise bank interest rates. The issue is, will these measures deliver and over what time frame? To answer, one needs to identify the causes of the current inflation and whether the steps taken address them?

Unorganised sector hurting

The Indian economy consists of the vast unorganised sector employing 94% of the workforce. By definition, they lack the bargaining power to demand a higher wage as prices rise. So, inflation hurts their purchasing power and since they have little savings they have to cut their consumption. The middle classes have to cut back on their savings and reduce discretionary items of consumption, like, consumer durables and semi-durables. They also shift to buying inferior goods. Thus, demand in the economy declines and the rate of growth of the economy tends to decreases.

The losses of the poor and middle classes become the gains of the businesses. So, the well-off sections earn higher incomes. But they hardly increase their consumption since they were already consuming the basics. They may marginally increase expenditures on luxury items, travel abroad and vacations. Partly this extra expenditure leaks out of the country in the form of increased imports. So, they cannot compensate for the decline of the expenditures by the majority of the citizens.

Increase in investment by businesses can raise demand. But, if consumption demand is down, they cannot sell more so, why would they invest more? That leaves the government to step in to increase its capital expenditures in real terms. But that is difficult unless the government is willing to raise the fiscal deficit. However, even if that is done, usually it is unable to compensate for the decline in demand from the private sector.

Thus, demand remains short and the growth rate of the economy declines. This is especially so for the unorganized sectors of the economy. But, the official growth data does not capture this decline. The implication is that the true growth of the economy is much less than what the official data indicates and the economy is stagnant or even declining at present

In brief, the country is faced with high inflation and at best a stagnant economy. This is a difficult situation to be in for any economy.

Causes of current inflation

Inflation has been high and rising for about a year. Wholesale price index (WPI) has increased more than 10% for 13 months. An important reason is that during the pandemic the government increased taxes on petroleum products to raise taxes. Since energy is basic to all production and distribution, an increase in its price impacts all prices.

Next, supplies got dislocated in India and abroad with closure of businesses. As the advanced economies revived with the decreased intensity of COVID, demand rose and globally the prices of various commodities like, crude oil, fertilizer and metals rose. There was shortage of containers for shipping and shipping charges rose sharply. Due to lockdowns and closures there was a shortage of computer chips with impact on electronics, automobile sector, etc., and their prices rose.

The Russian invasion of Ukraine has aggravated this already deteriorating global inflationary scenario. The US inflation level has crossed 8%, a high for the last four decades. The War has disrupted the supply chains further with critical supplies blocked due to war and the sanctions imposed on Russia. Supplies of wheat, sunflower oil, fertilizers, Nickel, Palladium, Neon gas used for computer chips manufacture and so on have been hit. Worse, the supplies of energy from Russia have been hit causing the global prices of crude oil to rise sharply.

Indonesia, has banned the export of palm oil since its production has been hit. China is using a policy of zero tolerance for COVID and imposing stiff lockdowns from time to time. That has disrupted supplies from there and it is the manufacturing hub of the world

Coal prices have risen globally so those Indian power plants importing coal do not find it profitable to function and that has caused shortage of electricity which again disrupts supplies. The early onset of summer in March end has impacted agricultural production and most notably the wheat crop. But vegetables and fruits also get impacted due to shortage of water. There is severe shortage of water for drinking in many parts of the country which adds to the family burden.

Dealing with current inflation

RBI has dealt with the issue largely as a monetary problem. Demand is sought to be reduced when demand is already short and growth faltering. One needs to consider, how the steps will overcome supply bottlenecks in India – the problems of agriculture or shortage of water or coal or of closed companies or the increased pricing power of the corporates that are raising prices or speculation in commodities. It is not in its remit to lower high indirect taxes on petroleum goods.

So, action has to be taken by the government. It can reduce indirect taxes and raise more revenue via direct taxes so that the deficit does not rise. The small and micro sector units need help to revive so that supply bottlenecks are reduced. Speculation by traders and profiteering by corporates also can be checked by government. Neither the RBI nor the government can do anything about the war in Ukraine or lockdowns in China which are aggravating inflation. But, government can help reduce inflation and its impact on the poor.

This article was first published in as Inflation is inching up: Is Government helpless?

Read another piece by Dr Arun Kumar on the Criminal justice system-Pacing up the sluggish Indian Police and Criminal Justice system in IMPRI insights.

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Read another piece on Covid lockdown by Dr Arun Kumar | Strategic and Effective Lockdown: Only Impactful Solution to the Second Wave

Read another piece on Covid lockdown by Dr Arun Kumar| Three Weeks Nation-wide & Impactful Lockdown: Need of the Hour amidst Second Wave

About Author

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Arun Kumar, Malcolm S Adiseshiah Chair Professor, Institute of Social Sciences, New Delhi

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