Much to the fear and embarrassment of the UPA government, inflation rate almost doubled during the three months of 2008 to reach the 39-month high mark of 7 per cent. Although 2008 began with inflation rate of 3.79 per cent for week ended January 5, prices rose as the year progressed.

Such a sudden spurt in prices has thrown the household budget of the common man into disarray, putting pressure on the government and the Reserve Bank to take steps to control the inflationary pressure.

What is Inflation exactly?

Inflation is a measure of rise in general price levels of goods and services. Inflation is measured by taking a set of goods and services, and then the prices of the items in the set are compared to prices one time period ago.

In India, inflation is measured based on the wholesale price index (WPI) which measures the change in prices of a selection of goods at wholesale prices. Inflation is primarily of two types - Cost push and Demand pull. Cost push inflation is due to rise in costs of input materials or labour, whereas demand pull inflation is due to increase in demand beyond installed capacity.

Inflation comes in many varieties. The worst variety, from the viewpoint of politicians, is food-led inflation. In a poor country like India, where half or more of family spending is on food, rising food prices spell electoral doom.

Inflation went up quite a bit in the beginning of last year (around seven percent) due to high liquidity in the markets (huge funds inflows in the form of FII and FDI). The RBI controlled inflation by tightening the monetary policy (raising cash reserve ratio and interest rates) and letting the rupee appreciate against foreign currencies. Inflation came well within the control limits in the second half of last year. However, inflation is going up again this year from the last few weeks. This week, inflation figures reached the 7% mark. The reasons of rising inflation this time are quite different from those last year.

What are the effects of inflation?

Controlled inflation is good for the economy as it increases motivation levels of people. The government, in consultation with the RBI, decides the inflation threshold in the country (current inflation threshold range in India is 4-5 per cent). The inflation target is one of the key parameters that go into determining fiscal and monetary policies.

When inflation accelerates, as is the case today, governments across the globe tend to panic and rush out with anti-inflationary packages. The government is panic-stricken today because food prices are going through the roof. Overall, wholesale price inflation has accelerated from 4.5% in January to almost 7% today, and looks headed for double digits. Consumer prices are rising even faster because of consumer panic. The consumer price index is available only with a lag of two months, but newspaper reports suggest that in some cities the consumer price of rice is up 20%, edible oils 40%, dairy products 12% and some pulses 20%.

Life in the four metros across the country is getting tougher for poor and middle class consumers as their budget for grocery and other food items have shot up by almost 40 per cent in the last one year, with Delhi being worst hit. The maximum surge in food prices was witnessed in the national capital, followed by Kolkata, Mumbai and Chennai.

What are the main reasons behind rising inflation?

Price rise of essential commodities
The prices of the basic commodities - milk, vegetables, cereals, dairy products, cement, steel, edible oil etc - have gone up quite significantly, especially in the last few weeks. This is due to supply concerns. There is fear in the market that the supply of basic commodities is not increasing in proportion to population growth. This has triggered a wave of speculation in commodities and hence the prices are going up rapidly.

Commodity prices rise at global level
Rise in commodity prices at the global level is another factor that contributes to higher inflation in the country. The correction in global stock markets resulted in a rise of commodity prices all over the world as investors are using commodities, especially precious metals, to hedge their risk.

Rising oil prices
Crude oil prices have gone up significantly in the last few weeks. Although the government is controlling fuel prices in the country, rising crude oil prices plays a crucial role in general price rise.

Mismatch in supply-demand
India’s economy is growing at around 7-8 per cent per annum over the last few years. The per capita income levels have gone up and as a result, the demand for many commodities has increased significantly. But the supply hasn’t shown such phenomenal growth.

Global panic
Two successive droughts in Australia, plus the diversion of one-third of the US maize crop to ethanol, have led to shortfalls in world production and low food stocks.

Attractive global markets for farmers

World food prices have skyrocketed. In an era of internet-savvy farmers who know exactly what food prices are in Chicago and London, they adjust their own actions accordingly. The government hopes that by banning exports, it can keep Indian food prices well below world prices.

This doesn’t seem very plausible because farmers, especially the bigger ones, will hold back their crop during the coming procurement season, hoping to sell at much higher prices in later months. That in turn will mean lower wheat arrivals in the procurement season and that shortfall will further spur inflationary expectations.

 

What is the government doing?

The government has already taken a host of fiscal measures like scrapping import duty on crude edible oils, banning export of non-basmati rice and pulses to check spiraling prices, threatening hoarders and black marketeers to stop unlawful activities, the impact would be felt only by the end of the month. If these measures can’t provide relief, A CRR hike could be next on the cards.