Inflation fears throw up policy dilemmas

Several interventions are being tried to cool prices but different measures might have conflicting impacts. Instead, a nimble, vigilant balance is preferable

Supply-side inflation shocks are making a habit of coming back. It started with the supply chain disturbances during Covid, got accentuated by the Ukraine war, and is now adversely affected by weather shocks destabilising food prices. From January 2020, the headline Consumer Price Index (CPI) has averaged more than the 6% upper tolerance band of the Reserve Bank of India (RBI), with even the more stable core inflation averaging 5.7%. It is true that inflation has suddenly become a global problem and the deviation from the target is much smaller in India compared to global peers. Still, these renewed pressures pose some difficult choices for Indian policymakers.

Tomatoes may have hogged the recent headlines, but the recent vegetable price rise is broad-based (PTI)

Global commodity prices have fallen from their Ukraine war peaks, but recent trends hint at stabilisation or some rebound. Global prices of rice, wheat, vegetable oils, and sugar need a closer vigil as geopolitical (such as a delay in a Black Sea deal) and climate risks (El Niño impact) re-emerge. Crude oil prices are also hovering close to uncomfortable levels. Extreme weather events have already affected winter crop supply dynamics. The monsoon arrived late and June rainfall was 10% below average, but parts of the country got flooded in July with 14% excess showers. With approximately 32% deficiency, August could be one of the driest ever. Eastern India still remains very dry with an almost 16% deficit. The critical question is whether the dry August is just a break in the monsoon or a sign of El Niño finally setting in.

If this turns out to be El Niño, the inflationary impact will depend on the damage to the summer crop, risks and mitigants for the winter crop, and the fiscal and monetary response. The sensitivity of agricultural production to rainfall has reduced over time with only three of the last 18 years experiencing an outright decline. That doesn’t, however, completely rule out the risk of lower yields on crops already sown. Also, if the current sowing trends persist, then it could be the third consecutive weak year of pulses production, leading to the threat of elevated prices. Vegetables remain another wild card, where the impact of erratic monsoons is even more difficult to judge. While it is entirely possible that the acreage under vegetables has improved following the sharp increase in prices, the yield on these could be affected by a prolonged dry spell. Tomatoes may have hogged the recent headlines, but the recent vegetable price rise is broad-based. The winter crop depends more on irrigation from water reservoirs and soil moisture content. Water reservoir levels are well above average in North, West, and Central India but weaker in South and East. For now, this suggests low risk for the key wheat crop. However, soil moisture could be a challenge if this prolonged dry spell ends with an early withdrawal of the monsoon.

A more sustained drop in food prices, especially vegetables, would require fresh supplies to hit the market but policymakers are clearly keen to curb inflationary pressures promptly. The interventions undertaken from the fiscal side include open market sale of food grains (rice and wheat), procurement and market intervention (tomato, onion and pulses), trade interventions (rice, onion, and edible oils) and imposition of stock limits (pulses and wheat). Monetary policy does not have an immediate role to play but obviously, the tone has turned cautious and liquidity is tightened to limit the spillover of food inflation to other prices.

Inflation control, ensuring adequate availability of foodgrains, supporting rural income growth, and maintaining fiscal stability are all laudable goals but different supply side measures might have conflicting impacts. The key policy challenge is how much market forces can be allowed to incentivise the supply chain to respond to price signals versus the extent of intervention required to reduce varied kinds of market failures. In the process, every policy intervention chooses its winners and losers. For example, repeated export restrictions improve the availability of critical crops for domestic consumption but could dampen future supply responses as farmers do not benefit from rising prices. In turn, the profitability of farmers is adversely affected. When the rural economy is already experiencing sluggish demand growth on the back of stagnant real wages, any negative terms of trade shock could worsen the demand outlook. On the other hand, any effort to reverse this trend and boost rural demand through a pre-election fiscal stimulus could perversely end up pushing inflation higher.

In a world with less openness to trade, strategic interventions in trade policy have become more common. However, uncertainty around trade policy could have longer-term ramifications on farmers’ choice of crops and development of the supply chains. Private investment in these export supply chains requires certainty in trade policy. Also, India has become a large player in the global markets for some products such as rice and wheat. India’s export restrictions have the potential of pushing up global prices and as a result, perversely increasing the inflationary risks if domestic prices move in sympathy.

Some interventions to reduce inflation have a fiscal cost (such as a potential cut in excise duty on petroleum products) which might be difficult to accommodate without expanding the deficit or reducing other kinds of expenditure. The government has generally followed a conservative fiscal stance with a much-improved quality of expenditure (higher capital spending). Abandoning that completely at this hour would not be prudent, especially if the food inflation spike is short-lived. The overarching need is to substantially reform and increase investments in post-harvesting infrastructure to smoothen supply and price volatility. Until that broader goal is reached, policymaking needs to avoid corner solutions of gravitating towards a single objective; a nimble, vigilant balance remains the preferred option.

Samiran Chakraborty is managing director and economist, India, Citigroup. Baqar Zaidi is economist, Citigroup. The views expressed are personal