Can RBI break the inflation spiral?

May 3, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The RBI must have been fairly exasperated with the country’s stubborn inflation which, in spite of the 2 percent increase in repo-rate in eight installments, did not at all budge. A bold approach has been made this time with 50 bps increase in repo rate in the hope that inflation will ease.

Why the present inflation occurred is fairly clear, why it has perpetuated is not. There are two routes for inflation to spiral up. First, the DA which government announces every 6 months to appease the employees, provoking at the same time the private sector to do the same. Second, the minimum support price (MSP) which government announces every season to appease the farmers. Not that the government has any option. It is the system that has been put in place that makes these adjustments inevitable.

How does it work?

The initial price rise may take place with a fall in agricultural production. With that there is an increase in food prices which have a heavy weight in the consumer basket. An increase in DA follows to compensate the employees for the rise in the cost of living.

The combination of the increase in wages and salaries in turn raises the cost of production. It may appear that wages and salaries constitute less than 10 percent of the cost and as such the rise in cost would be much less than the increase in wages and salaries.

This is not so. For, the increase in wages and salaries also take place in sectors which produce raw materials, generate electricity, transport materials and products, and so on. The final impact of the original inflation which begins in the agricultural sector gets transmitted to all other sectors.

This is not where it ends. The government has to protect the farmers as well by ensuring MSP for all major agricultural products. What this means is that government has to maintain parity in prices of agriculture and prices of manufacturers and services.

Since prices of manufacturers and services rise, the government goes for a second round of adjustments in agricultural prices. New minimum crop prices are announced, irrespective of what happens to agricultural production. It may well be a bumper crop which government perforce has to buy and store. Nevertheless crop prices have to rise to keep parity, raising the cost of living simultaneously. With that, government is ready to announce the second round of DA.

With this system, inflation, once it starts, can on for a long time. It can taper off after a while because there are sections of people who do not get either DA or MSP. They are the ones who have to really bear the ultimate burden of inflation by cutting consumption.

They are mainly the unorganized labour working in agriculture and other sectors of the economy. Now even some of them get some protection under the national rural employment guarantee scheme. It has therefore become more difficult to break the vicious circle of DA and MSP. RBI may fiddle with repo but can do little to break the inflation spiral.


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