This note is on [speech](https://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=651) delivered by Shri. H. R. Khan, Deputy Governor, Reserve Bank of India at 10th National Management Seminar – 2011, Bhubaneswar on The Shrinking Money: Combating Debt Crisis and Inflation on December 10, 2011 organized by The Asian School of Business Management). ## Introduction 1. In the global context, shrinking money could possibly be related to advanced countries’ fiscal excesses which have been fully accommodated by their respective central banks in conducting monetary policies. 1. ==Monetary policy has always remain subjugated to the fiscal excesses and its impact, despite inflationary risks in the medium-run from the persistent easy monetary and liquidity conditions created by their central banks.== 2. Monetary policy strategy in advanced economies has explored new options, particularly after hitting zero nominal interest rate bound, such as “quantitative easing” and “twist operations” but their effectiveness in delivering a durable robust recovery in growth has belied expectations. 3. In that sense, it could be “shrinking scope for monetary policy”. 4. India, however, does not face these constraints in the conduct of its monetary policy. 5. On a second thought, therefore, I looked for an answer from the domestic macroeconomic context. Whether shrinking money refers to “shrinking value of money” because of the persistently high inflation that we have been experiencing for more than two years now? >Is it about what monetary policy could do about inflation in an environment of large borrowing programme of the government and inadequate fiscal and other structural response to address the supply side pressures on inflation? I realised that it must be the above, since I am from RBI, an institution which has been subjected to intense public scrutiny in last about one year or so for its monetary policy response to contain inflation and anchor inflation expectations. I would try to cover in my address the way we see the recent inflation path in terms of its determinants, and why monetary policy matters so much, even if that alone is not sufficient to ensure a low and stable inflation environment. 1. Monetary policy can still ensure a fast softening of inflation but only at the cost of large sacrifice of growth, which is equally non desirable as high inflation. 2. Low inflation and robust growth- both are essential to improve economic welfare. 1. Fiscal policy also has a major role in inflation management, both in terms of containing government demand in the short-run and augmenting the supply situation in the medium-term. 3. A supportive fiscal environment can improve the effectiveness of the monetary policy. 4. ==I will, therefore, also cover some of the fiscal issues in this address, and by doing so, I will try to touch upon some other dimension of the overall theme of this seminar.== ## Why inflation has persisted despite RBI’s significant anti-inflationary monetary policy response? ### Background 1. A "high" inflation has to be seen as a relative concept. It could be high relative to either past averages or the inflation goal of the RBI. 1. Prior to the global crisis, the average WPI inflation over the five year period 2003-04 to 2007-08 was about 5.5 per cent. 2. ==Since January 2010, however, the WPI inflation has remained within a range of 8 to 11 per cent in each of the 22 successive months, which is high relative to what we experienced before the crisis.== 3. This is also when RBI’s monetary policy continues to aim to keep inflation in the range of 4 to 4.5 per cent. Hence, 8 to 11 percent is clearly above the stated comfort level of the RBI. 2. *Growth:* We India avoided a financial crisis at home, but there was some moderation in growth. 3. *Inflation:* India was already dealing with double digit inflation (by mid-June 2008). But fall in global commodity prices, domestic slowdown in demand led to significant decline in inflation by the end of 2008-09. In the first 7 months of 2009-10 inflation hovered at below 2 per cent. 4. *Deflation:* In first 2 months of 2009-10, the year-on-year inflation was negative, when many had started asking RBI whether India faces the risk of deflation. > The inflation situation deteriorated so fast thereafter, over successive phases, with contribution to the inflation build-up coming from different items covered in the WPI. ### Inflation 1. [[#**Food Inflation **|Food Inflation]] 2. [[#**Crude Oil Prices **|Crude Oil Prices]] 3. [[#**Non-Food and Non-Fuel (Core Inflation) **|Non-Food and Non-Fuel (Core Inflation)]] #### Food Inflation 1. 2009-10: There was 22 per cent deficiency in South-West monsoon. This created a supply shock. Despite high food stocks and resilient agricultural sector output, the adverse expectations associated with this supply shock kept food inflation high throughout the year. 1. The contribution of food inflation to headline WPI inflation was almost 100 per cent but non-food inflation was very low in the first half of 2009-10. 2. 2010-21: Again Food inflation remained high on a sustained basis, despite record food grains production and a normal South-West monsoon this year. This is due to change in certain dynamics of food inflation changed in recent years which include: **Reasons:** 1. The growing demand supply imbalance, more so in protein based food items –_Production and productivity enhancement in food articles have not kept pace with increasing demand and income level of the growing population of the country._ 1. With rising per-capita income, the dietary pattern could also change, away from staples and in favour of protein rich items. 2. **This is what being experienced in India in recent years consistent with  the  Bennet’s Law which suggests that as incomes increase, the proportion of starchy staples in the food basket declines relative to the share of more expensive sources of calories**. 3. Supply of protein based food items such as pulses, milk, eggs, meat and fish have not increased as much as one would expect in response to higher prices, while demand continues to grow. 4. Data on expenditure pattern in both rural and urban areas suggest that the shares of expenditure on protein food in total expenditure have increased. 5. A high protein inflation in the range of 25 to 34 percent was observed over successive eight months between November 2009 and July 2010. 1. Significant increases in rural wages, particularly in the post-MGNREGS period 1. Inclusive growth is essential to make the growth process sustainable in a democracy of 1.2 billion population. ==But there could be occasional tradeoffs between inclusive growth and inflation, particularly when wage increases do not reflect corresponding increases in productivity, and higher transfers of purchasing power do not accompany measures to improve the supply situation of commodities on which these higher fiscal transfers could be spent. == 2. Rate of increase in wages has been in excess of comparable consumer price inflation (CPI) in rural areas, according to the data on the increase in rural wages over last several years. 3. MGNREGS, guaranteeing 100 days of employment per year is in operation since 2006, and recently MGNREGS wages have been indexed to consumer price inflation in rural areas. 4. Significant step up in per-capita expenditure levels - Available data suggest that average nominal per capita expenditure increased sharply in the second half of last decade (2005-10) compared to the first half (2000-05), from 3.6 per cent to 10.5 per cent in rural areas, and from 5.3 per cent to 10.9 per cent in urban areas. 5. Trend growth in agriculture sector of about 3 per cent - This along with wage increases at high rate in rural areas exerted both cost-push as well as demand-pull inflationary pressures. 2. **Large increases in minimum support prices (MSPs)** 1. In India, there is a long standing debate on the role of remunerative price incentive to improve production of farm output, given the implications of such an approach for food inflation. Even when a segment of the population benefits from subsidised provision of food, large increases in MSPs could add to pressures on food inflation by providing a floor to market prices. Even though there have been occasional reports of procurement taking place at below MSP or market prices at times falling below the announced MSPs, in general, market prices hover at or above the announced MSPs. 2. In recent years, the rate of increase in MSPs has been large. For example, the average increase in MSPs for rice during 2007-2011 has been 13.6 per cent, as against 1.8 per cent during 2003-07. For wheat, over the corresponding periods, the increases in MSPs have been 11.3 per cent and 4.0 per cent, respectively. 3. Logjam in case of high MSPs 1. High MSPs generally reflect high input costs, such as wages, fodder, diesel oil, fertilizer and pesticides become inflationary 2. In absence of MSPs, when input costs increase, such as that of wages, fodder, diesel oil, fertilizer and pesticides, farm production could be adversely impacted, which in turn could be inflationary. 3. So this a logjam. 4. The best possible solution to this logjam could be higher productivity, and raising productivity remains a major medium-term challenge for the agriculture sector in India. Higher productivity is the only means that could improve the income of the farmers while also helping in containing food inflation. *Recall that total value = price $\times$ quantity (so increase in qty could be the solution here)* 5. But yield remains insufficient. Among the G-20 countries India’s productivity in rice and wheat is one of the lowest. After the significant increase in yield following the green revolution, yield levels have stagnated relatively in recent two decades, while population and per-capita income have increased and the population below poverty line has declined, reflecting growing demand with much improvement in per-capita availability of foodgrains. 3. **High global food prices** 1. Even when much of India’s food grains may not be traded physically cross-border, international price trends do influence domestic prices. 2. Global food prices had increased at a rapid pace before the global crisis, softened somewhat after the crisis, before rising back to the pre-crisis level in the recent period. It was expected that by the FAO and other international agencies indicate that agriculture prices, which reflect the growing demand arising from food, fuel and feed requirements, would remain elevated over the medium term. 3. What is important for India is that even when global food prices may drop below domestic food prices, import option for India as a means to contain food inflation could be limited, since once India enters the global market on the buying side, that could raise global prices. 1. *This is due to speculation in price:* Global commodity markets track demand-supply positions across major countries in a forward looking manner, and at times assessment about shortfall in supply relative to demand in one single country could inflate international prices. 4. **Rigidities in supply chain** 1. Intermediaries tend to control the supply chain in times of price rise to their advantage 1. For a large country of India’s size and population, distribution networks – from farm gate to retail level – occupies a central role in the determination of prices at different levels, and hence in conditioning food inflation. The phenomenon of 1-2-3-4 is often cited in this regard to show how while the farmer gets one Rupee and the consumer pays four Rupees, the intermediaries pocket the rest. In an inflationary environment, there could be a tendency to manage the supply chain to the advantage of the middle men. 2. *Solution?* 1. This calls for greater competition (1) and stricter rules (2) to deal with anti-competitive practices. 2. Better transportation (3) and warehousing facilities (4) could also lower costs and reduce waste of perishable products. 3. Multi-brand retail (5) has been seen as a possible means to improve the supply chain that will be beneficial to both producers and consumers. Given the current debate on the subject in India and varied international experience, multi-brand retail has to be seen as a potential instrument whose effectiveness, however, could be known only over time. #### Crude Oil Prices 1. Besides food, fuel has been another major source of price pressure, which is directly linked to international trends in crude petroleum prices. Indian basket crude price had scaled to as high as USD 132.5 per barrel in July 2008, _i.e._ just before the global crisis. The impact of the global crisis in the advanced economies was so strong, that it dragged international oil prices down sharply, and the Indian basket crude price fell to as low as USD 43.2 per barrel in February 2009. Since then, notwithstanding the persistence of weak growth momentum in advanced economies, oil prices have bounced back to high level. In April 2011Indian basket crude price reached USD 118.6 per barrel, before softening thereafter somewhat, but still remaining range bound at high level between USD 110 to 105 per barrel. 1. In India, changes in international crude prices are not fully passed through to domestic prices of petroleum products, because of the administered pricing mechanism. While petrol prices have been deregulated since June 2010, prices of diesel, LPG and PDS kerosene are still regulated to insulate consumers against high global crude oil prices, which, however, inflate the subsidy bill with every increase in oil prices. ==While in the short-run the impact on inflation gets suppressed through administered pricing, the subsidy induced pressure on the fiscal position becomes a risk to the inflation situation in the medium run. == 2. Moreover, subsidised pricing does not encourage the desired level of energy conservation, which is critical given our high level of dependence on oil imports. 3. Consumption trend - According to the draft of the approach to the 12th five year plan (2012-13 to 2016-17), India’s import dependence on oil, natural gas, and coal is expected to increase 76% in 2010-11 to 80% by end of 2016-17, from 19% to 28.4%, and from 19.8% to 22.1% respectively. 4. Price expectations - Current assessments about oil price trends in the medium-run suggest that oil prices may only firm up further rather than moderate. Despite a prolonged period of growth weakness in the advanced economies if oil prices have remained firm over successive months, when the global economy returns to a durable phase of higher growth, oil prices could only harden further, unless some technology breakthrough improves availability of alternative sources of energy significantly, which though looks quite unlikely. 5. Subsidy -> Weak Fiscal situation -> Inflationary 1. ==The extent of India’s import dependence on oil and the expected trend in oil prices in the medium-run suggests that subsidised provision of fuel and power to 1.2 billion population could be possible only with a very weak fiscal situation, which in turn will be inflationary and defeat the very objective behind subsidised provision of fuel. Despite suppressed inflation resulting from administered pricing of certain items, because of the firm international oil prices, fuel group inflation has been in double digits for 21 consecutive months now.== 2. The inflation process thus started from primary food and fuel, and these two together accounts for as high as 29% of total weights in WPI. #### Non-Food and Non-Fuel (Core Inflation) 1. Why it affects inflation? ==The increase in these prices spills over to non-food and non-fuel (or the core) inflation through both higher input costs and higher inflation expectations getting reflected in wage revisions. In the presence of strong demand conditions, the spillover could be faster, to cause a generalised inflationary process.== 2. Data: In India, non-food non-fuel manufactured product inflation was negative in the first half of 2009-10 and remained very low, i.e. less than 4 per cent in the second half. In the first eight months of 2010-11 also it hovered in a range of 5.3 per cent to 5.9 per cent. Since February 2011, however, it has remained at or above 7 per cent over nine successive months, which is clearly above the RBI’s comfort level. ### Why RBI has raised its policy rate 13 times? Why RBI has raised its policy rate 13 times? when much of the inflationary pressures are from food and fuel, which would not respond to monetary policy actions. 1. Yes, it is correct to say that food inflation cannot decline because of higher policy rates but the rationale for monetary policy action has to be seen from two major standpoints. First, a generalised inflation process cannot persist in the absence of aggregate demand and, hence, if monetary policy succeeds in containing aggregate demand, that could help in softening inflation. Containing non-food non-fuel manufactured products inflation through policy induced moderation in demand is what monetary policy could achieve. 2. Second, even when monetary policy cannot address food and fuel inflation directly, it can certainly prevent inflationary expectations getting worse under the influence of high food and fuel inflation. If monetary policy could anchor inflationary expectations, then it can influence the wage and price setting behaviour in the economy, and thereby help in containing inflation. ## Related Notes 1. [[Inflation]] 2. [[Inflation and RBI]] 3. [Flexible Inflation Targeting (FIT)](Flexible%20Inflation%20Targeting%20(FIT).md) 4. [[Inflation Puzzle - 2013 by Deepak Mohanty (High Inflation while growth is falling between Jan-10 to Dec-11)]] ## References ### Speeches 1. H. R. Khan. (Jan 09, 2012). ==The Shrinking Money and RBI’s Monetary Policy==. Address delivered by Shri. H. R. Khan, Deputy Governor, Reserve Bank of India at 10th National Management Seminar – 2011, Bhubaneswar on The Shrinking Money: Combating Debt Crisis and Inflation on December 10, 2011 organized by The Asian School of Business Management. [Link](https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=651) 2. [More](Inflation%20and%20RBI.md#References)