THE SILENT KILLER OF ECONOMY

Inflation is the rate of increase in prices over a given period of time.

What is inflation?

Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated – for certain goods; food or service; a haircut. In another way it can be said that - inflation reflects a reduction in the purchasing power per unit of money, a loss of real value, in the medium of exchange and unit of account within economy. However, if the price of only one commodity rises sharply but prices of other commodities fall it will not be termed inflation, similarly due to rumors if the price of commodity rises, it will also not be termed as inflation.

Causes

Factors that help determine inflation in India are: demand factors, supply factors, domestic factors and external factors. First, demand factors, in this total demand exceeds the total supply, for example, a country has a capacity to produce 10lakh products where as their demand is of 20lakh products, here the demand is becoming a actor for inflation. Second, supply factors, it happens due to scarcity of supply, this may be due to drought or if labors expects more wages – might lead to higher prices of products. Third, domestic factors, this inflation impact is high in the countries of developing economies and underdeveloped economies, because the financial market creates a weak bonding between the interest rates and aggregate demand. And, fourth, external factors, the exchange rates are also a factor that causes inflation.

Types

Broadly speaking inflation is divided into the following, and they are: creeping, galloping, hyperinflation, open, suppresses and hidden inflation. Creeping inflation; is when inflation does not exceed the rate of production growth. Generally creeping inflation is less than 10%. Galloping inflation; is when rate of inflation exceeds the rate of production, and this type of inflation is from 10% to 100%. Hyperinflation; here inflation is out of control and price increases rapidly as the currency loses its value. This is over 100%, barter trade emerges: the most famous example of hyperinflation is Germany after World War I and Hungary after World War II. Open inflation; in this - economic imbalance is accompanied with rising price level. Suppressed inflation; in this government steps in to stop the rise of price level by administrative means, which leads to a situation of extreme scarce commodities and shadow economy. Hidden inflation; here government impose strict control to curb price inflation, producers are forced to sell the product at the price required. This means producers cannot sell their products at higher prices to attain profits; therefore they lower the quality of product. This leads to the selling of lower quality products in the market at higher prices, hence the name hidden inflation.   

A walk down memory lane

After the Second World War inflation has been a permanent characteristic of Indian economy: be it political crisis, partition of country, social upheavals, growth of population, need for expansion of money supply, the continuous rise in demand of goods and services etc have all given impetus in escalating inflation in India. In 1943 Chintaman Dwarkanath Deshmukh, one of the finest financial minds, was appointed as the first Indian Governor of the RBI. He also went on to become one of its longest serving finance ministers of the country. The problem he faced as RBI Governor was the debt the colonial power had accumulated to India during World War II. During the 1950s the annual average inflation was just 1.67% with its rate varying from -12.5% in 1952-53 to 13.8% in 1956-57. The deflation was due to the bumper agriculture growth; but the following year brought back higher inflation due to investment demands of the second five year plan, the inflation effect was extenuated due to the crop failure during the three years 1954-55, 1955-56 and 1957-58. In the 1960s inflation accelerated due to two wars; 1962 and 1965, and the crop failure of 1965-67 which caused agriculture production to fall more than 16%.Period from 1949-1969 saw nationalization of 14 commercial banks because of the devaluation of rupee. Inflation became a serious issue in the early 1970s; it reached the level of 20% in 1973-74 and 1974-75, mainly due to failure of kharif crops and the 1973 worldwide oil shock. The domestic agriculture shock was accompanied by a sharp increase in domestic demand.  Inflation was negative in the year 1975-76 in spite of poor availability of food grains; this was partly due to the severe monetary and fiscal restraint that was in operation from mid 1973-74 onwards. During 1979-80 and 1980-81 Indian economy suffered from both internal; drought of 1979, as well as external; second oil price rise, shocks. The year 1987 was dominated by what was initially considered to be ‘one of the worst monsoon failures on record’ but in spite of this, it did not turn out to be that bad, the reason was partly due to strong agriculture recovery of 1988-89 and 1989-90. During 1990-91 through to 1997-98 the country witnessed inflationary tendencies with four of the seven years with rate of price between 10% -15%, however this inflation was different from the inflation of the early or the late eighties, because of the following reasons: first, owing to faster growth in service and industry sectors. Second, for ten years 1985-86 to1995-96 the fiscal deficit remained close to 7% of GDP. Third, Indian economy was opened to the international market. In short, inflation during this period was structured as the economy was getting adjusted to a new policy regime with the primary factors taking a back seat. Then the inflation rate declined from an average of 11% during 1990-95 to about 5.3% during 1995-96 to 1999-00; due to de-acceleration in growth rate of money supply from 18% in 1990-95 to 16.3% in 1995-00. On the macroeconomics front, Indian economy entered a new phase in which the country achieved its highest consecutive five years average growth since independence; at 8.8% between 2003-04 and 2007-08. And more importantly both WPI; Wholesale Price Index, and CPI; Consumer Price Index, which was a major concern in previous decades was below 5% from 2000-01 till 2004-05. Inflation once again fell below 5% in 2007-08 on account of mild trends in fuel and power group, and manufactured prices. Compared to 20007-08, rate of increase in overall WPI inflation doubled in 2008-09 due to food prices. Food inflation that was 9% in 2008-09 increased to about 15% in the next two years; 2009 and 2010. Thereafter, CPI and WPI food inflation in 2011-12 dropped to close to 7%. This was not sustained for the next few years, and fortunately for the economy in 2014-15 the explosive trends in food prices have earned substantially; at 6%.

Change in paradigm

On taking office in September 2013, the 23^rd RBI Governor, Dr. Raghuram Rajan, highlighted the importance of low and stable expectations of inflation. Furthermore, Dr. Rajan announced a review into RBI’s monetary policy frame work; led by Dr. Urjit Patel; then Deputy Governor and future 24^th RBI Governor, which subsequently recommended the adoption of a flexible inflation targeting regime based on headline consumer price inflation. This contrasted with previous monetary policy statement that focused on the WPI. This was a common concept that – ‘as inflation came down, bankers lowered deposit rates, so savers were unhappy.’ Thus Dr. Rajan had to explain ‘how coming down of inflation had benefit for the savers.’ And Dr. Rajan explained this with his now famous ‘Dosanomics.’ He said – ‘say a pensioner wants to buy dosa and at the beginning of the period, they cost Rs.50/- per dosa. Let us say he has a saving of   Rs.1, 00,000/-. He could buy 2000 dosas with the money today, but he wants more by investing. At 10% interest, he gets Rs.10, 000/- after one year plus his principal with dosa having gone up by 10% in price to Rs.55/- he can buy 182 dosa approximately with the Rs.10, 000/- interest. Now what happens when inflation comes down? At 8% interest, he gets Rs.8, 000/- in interest. With dosa having gone up to Rs.5.5% in price each dosa cost Rs. 52.75/- so he can now buy only 152 dosa approximately with the initial payments. So the pensioner seems to be right to complain. But remember, he gets his principal back and that too has to be adjusted for inflation. In high inflation period, it was 1818 dosas, in the low inflation period, it is worth 1896 dosas. So in high inflation period, principal plus interest are worth 2000 dosas together, while in a low inflation period it is worth 2,048 dosas. The pensioner is about 2.5% better off saving in the low inflation period in terms of dosas.’ At the end of Dr. Rajan’s term as RBI Governor CPI inflation was 4.39% in September 2016 down from 10.5% in September 2013. Then CPI inflation by March 2017 was a little higher at 5%; Urjit Patel was the RBI Governor.  And as recent as May 2019, the inflation rate is 3.05% which represents a modest reduction from the previous annual figure.   

How to calculate inflation?

The WPI and CPI are the main price indices in India, where WPI measures prices received by producers of good, on the other hand CPI measures price facing consumers at the retail level. The WPI is produced by the Indian Ministry of Commerce and Industry, and the data are collected at the first point of bulk sale in the domestic market. The prices used are wholesale prices for primary articles, administered prices for fuel item and ex-factory price for manufactured products. The WPI is calculated using the Laspeyres formula, which measures the change in the cost of purchasing the same basket in the current period as was purchased in a specific period. A disadvantage of this index is that it will be biased if the composition of sales in the wholesale markets is changing and the weights are not regularly updated. And the weight for components of WPI is derived from their share of gross output in current price terms. In the case for CPI, two different government agencies: Ministry of Statistics and Programme implementation; MOSPI and the Ministry of Labour and Employment, publish a number of consumer price indices – RBI prefers the MOSPI CPIs. The CPIs places a much larger weight on food items, than WPI since it is weighted on the basis of household expenditure: food, beverages and tobacco have a combined weight of nearly 50%; compared to around 25% in the WPI. Also, CPI includes components such as services and housing. The reason why RBI have preferred CPI instead of the previously used WPI are the following: first, the fact that prices in the wholesale market are not purely producer prices or consumer prices makes the WPI difficult to interpret. Second, the WPI does not capture the movement in the prices of services. And third, the use of the CPI in wage contract and negotiation, and as a reference for the provision of welfare benefits means it is relatively well known to the public.   

Double whammy of inflation

Low inflation is often a sign of well run economy but like quickly falling weight, it may not always be a sign of health if it keeps falling. In February 2109, the CPI grew by 2.57% against 4.44% a year ago, and the consumer inflation has been hovering around 2% in 2018-2019 mainly due to food inflation. While low inflation is good, but a drastic fall in inflation has its negative effects: they not only hurt the farmers, but also restrict the growth of salary. Take the example of falling oil prices, in a way falling oil prices saves the motorist money on petrol. But imagine if the price of the car/bike itself were to start falling – so instead of buying a new vehicle this year the consumer things why not buy it next year, when it might be more cheaper. The crux of the story is ‘a little inflation encourages consumer to buy sooner and this boots economic growth.’ It is good to remember that ‘when inflation is too high or too low’ it is not good for the economy; as inflation will always reduce the real value of money, the old adage holds true ‘excess of everything is bad.’ 

                 

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