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In Budget-making, inflation is best ignored
February, 27th 2007

Perhaps, the best thing for the Finance Minister to do is relax and concentrate on carrying forward the growth momentum than to think too much about the inflation numbers and seeking to provide intermediate solutions to contain it.

The inflation figure calculated as the annual point-to-point change in the Wholesale Price Index (WPI) stood at 6.63 for the week ended February 10. Inflation, breaching the psychological mark of 6 per cent, generated tremors across the economy, and the general consensus was that the supply constraints are fuelling the price rise.

While there was a consensus on the cause, not much thought appears to have gone into the prescription for cure. The Reserve Bank of India raised the Cash Reserve Ratio and the repo and reverse repo rates, while the Finance Ministry banned export of key food items and cut import duties on some items. The academia, criticising both the RBI and the Finance Ministry, suggested such remedies as taxing excess money and curbing asset price raise.

Yet, two fundamental questions remain unanswered. First, is this really a panic situation? Second, what will be the effect if everybody tries to do something about the current inflation?

The answer to the first question is a `No' because of the following reasons. Simple economic wisdom tells us that a booming economy with an expected 9 per cent real growth rate is a platform ideal for the traditional Phillips Curve to work. In other words, inflation is part and parcel of the boom and it is impossible to avoid it in the short run without compromising growth. As the economy moves forward, the supply-side bottlenecks will automatically be taken care of by the market and ease the inflation.

Price index construction

The other important issue that gets little notice is the very construct of the price index. The revised series with the base year 1993-94 consists of 435 commodities and is classified into three major groups (i) primary articles; (ii) fuel, power, light and lubricants; and (iii) manufactured products. Laspeyres Index is used in the construction of the index, with different weights. This approach has been much criticised by academics and policy-makers around the world. In its December 1996 report, the Boskin Committee that reviewed the construct of the Consumer Price Index (CPI) in the US, said that use of Laspeyres Index, which finds the cost of purchasing a fixed basket of good representing the base year and then the cost of buying the same basket now, tends to overstate the rise in the cost of living. The report listed four types of biases of these index estimates and concluded that the constructed index overstates the inflation figure by around 1.1 per cent per annum. Out of four biases listed in the report, the substitution bias and the quality and new goods bias get much attention.

The elementary substitution bias can be illustrated through a simple example. Consider a base period 1 and a current period 2. Two commodities, coffee and tea, both costing Re 1 a kg, and a total of 100 kg each, are consumed by the economy in the Period 1.

Subsequently, the price of coffee rises to Rs 1.6 and tea remains at Re 1. With prices up, people tend to look for a substitute for coffee. The consumption pattern will now change to 80 kg of coffee and 120 kg of tea. In this situation, weights of consumption for coffee and tea change, with the latter getting higher weight. But the index, because of the fixed weights assigned in both periods, will have an upward bias.

The biases

The quality and new goods bias are emerging because the index takes into account only the quantity, not the quality, of a product consumed. Also, it takes time for new products to find a place in the price index basket. With such biases in the construction, the WPI could well be overstated, and over-reacting could bring down the euphoria in the economy and slow it down.

There is an urgent need to have separate indices for essential commodities, asset prices, and other general manufactured products. A monetary policy can be effective only when it is used in a situation where the inflation is rising and the growth rate is stagnant or not high enough to subsume the inflation. There would be a compelling reason to intervene in a booming economy if the price rise is affecting people below the poverty line.

For this it is necessary to decompose the aggregate, deceptive inflation measure to examine what prices are rising. If the prices of necessary goods are rising, then the intervention can be justified. But, remember, poor normally tend to substitute a costly good with a cheaper alternative, as the rigidity in altering the composition of the consumption is generally low. With the substitution bias, even this cannot be captured by the index.

Weak aggregation

Instead, if the prices of the manufacturing goods and others are rising, which normally enter the consumption basket of people above the poverty line (who incidentally are also enjoying the benefit of the boom), the idea of intervention may not be sound.

With such weak aggregations, the price index will tend to induce panic in the economy whenever there is a relative price change. Everybody then starts responding to contain it.

Higher inflation is a major cause of worry for any economy as it distorts effective resource allocation. On the other hand, this is also true when the government and monetary authorities blindly respond to contain it. In the current situation, the fact is that inflation is due to supply constraints and the best remedy is to work on removing supply-side bottlenecks or wait till the market adjusts itself.

The best thing is for the Finance Minister is to relax and concentrate on carrying forward the growth momentum with more reforms than to think too much about the inflation numbers and seeking to provide intermediate solutions to contain it. Sometimes, the best response for a crisis is to stay quiet.

S. Raja Sethu Durai
Ragupathy. V

(The authors are, respectively, Research Fellow and Graduate Student at the Madras School of Economics, Chennai.)

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