How effective are governments and central banks in controlling the economy? This question has become relevant in the face of high inflation throughout the world. Central banks everywhere have started increasing their policy rates or are contemplating the same. Governments, too, are trying to control inflation, a recent example from India being the Centre’s decision to reduce the excise duty on fuel products. Will this help to lower inflation?
Inflation has become a multi-pronged problem, with various factors contributing to its rise. The global case of crude oil prices zooming to the current level of ~$110 a barrel is one. Crude oil enters the prices of farm products indirectly as it is used for transport, running generators, procuring inputs, etc. The disturbance caused in the edible oil balance due to sunflower-oil exports from warring Russia and Ukraine getting cut off is another factor, as it has led to shortages and higher prices. This has fed into the prices of other edible oils; Indonesia spiced up the situation with its ban on export of palm oil some time ago (this has been withdrawn since). A third factor is that the supply of wheat has been affected as exports from both Russia and Ukraine have been removed from the global pool. This has led to a shortage and higher prices, leading India to react by banning its exports. Fourth, all manufacturers of food products will now face the challenge of higher costs of wheat and edible oils, which will lead to higher input costs; the spike has to be passed on to the consumers at some stage.
Baked products, dining out, and processed foods will become dearer on this score. Fifth, Russia is also a major supplier of oil, gas, iron ore, and coal. With the sanctions announced by the West, the supply of these commodities to the global basket has come down, leading, again, to higher inflation. The indirect impact is on the price of fertilisers, whose production uses significant quantities of natural gas. Sixth, post the pandemic, Indian manufacturers of both goods and services have been passing on the higher input costs to the consumer, which is why the CPI index for goods and services has been rising. Therefore, a war that was endemic to one region has had wide ramifications for the supply of commodities as well as global inflation.
The steps taken by the Indian government are commendable. Despite stiff pressure on the fiscal balances, a decision was taken to lower excise duties on fuel products and edible oil imports; this could lower the rate of inflation. But it will not be able to bring it down to, say, 4% or even 5%. Taxes are critical in the case of energy products as the share in the total price can be as high as two-thirds. But, for others, the benefit can be only at the margin. Lower taxes on import of edible oils can lower the price by, say, Rs 5-10 a litre, but can’t take the retail prices back to the Rs 120-140 levels seen last year. One will still have to fork out, if not Rs 200 plus per litre, something in the region of Rs 180-200. Therefore, the protection that can be provided by the government through tax cuts can be partial, and there are limits to which this can be done.
Central bank positions, too, are quite singular. We all know that around 85-90% of the components of CPI are not linked to leverage, which means that interest rates cannot influence demand for these products. In fact, what can be the decisive factor in reducing demand is ironically inflation, because high edible oil prices will reduce consumption for the average household; this something higher repo rates cannot do.
Therefore, RBI’s action and probably prospective measures on increasing interest rates can be looked at in two ways. One is that, to the extent that rates are raised, the pace of activity will slow down, which is a must for monetary theory to work. This will ensure that, in this situation, a parallel demand-side force doesn’t develop. The second is that RBI will have to try and get back to the situation of positive real interest rates. This is a challenge for all central banks. Even for the Fed, dealing with inflation of 8%, at a rate of 3%, there will linger a negative real rate till inflation recedes. The same holds for us. If inflation remains at, say, 6% for this year, can we have a repo rate of above 6% (even 6.5%)? This will hurt investment for sure. Hence, the market expectations need to be moderated.
There are limits to which policies can work. All governments would like their citizens to be happy. Even the most selfish regimes would ideally like to have a happy population to stay in power. Yet, as has been seen during the pandemic, negative growth resulted everywhere. Similarly keeping interest rates close to nil in the West has not quite brought about any resilience or strength in these economies. This is the inflation conundrum today.
The author is Chief economist, Bank of Baroda
Views are personal
