Essays

Inflation, to one degree or another, has become a fact of life. It is defined as a sustained increase in the general level of prices for goods and services. As inflation rises, purchasing power decreases, fixed-asset values are affected, companies adjust their pricing of goods and services, financial markets react and there is an impact on the composition of investment portfolios. The impact of any upward trend in prices is felt by consumers businesses and investors.

Inflation is not intrinsically good or bad, but it certainly does impact the investing environment. Changing prices can affect financial statement market environments and investment returns. Hence, the reserve Bank of India takes steps to manage inflation and the pace of economic growth. If inflationary pressures are building and economic Growth is accelerating, the Reserve Bank will act in a manner so as to increase the cost of borrowing and slowdown the economy. Controlling and reducing inflation is one of the key issues facing the government today. Only sufficiently harsh monetary measures can bring down inflation faster. But the intent is not to 'zeroise' inflation but kill 'inflationary expectations'. For that, the market must believe that inflation will not exceed the cost of borrowing. Hence, the focus must obviously be on inflation-sensitive sectors and goods. The current concern is clearly about food and primary articles, where price increases are in the region of 20 per cent and the import-dependent fuel economy, which is hostage to rising global energy prices. As for food related inflation, for example, if rabi harvests are encouraging it could compensate the kharif shortfalls, leading to a decrease in food prices. So, the food inflation about which people worry the most goes up and comes down on its own. There is precious little monetary policy can do about it.

The inflation problem is considerably narrower but more difficult to manage. For many years now, manufactured goods have stayed out of the inflation limelight, thanks to the stiff global competition in the market for branded goods. The erosion of 'brand equity' is another factor restraining the prices of manufactured goods. For example, the market share of MNCs in low technology products of daily use such as detergents gents has been shrinking. Secondly, food and fuel consumption are inelastic,, being the necessities of existence. Normally, the purpose of monetary actions is to curb aggregate Demand. A punitive rate rise will surely drastically slash the demand for and spending on 'discretionary' goods without impacting the prices of essentials. As far as items of mass consumption are concerned, there is little doubt current interest rates are speculation-friendly. The advent of futures exchanges and futures trading in many agricultural commodities is conducive to non-supply factors driving up prices with no benefit to growers. In fact, even making credit costlier may have little effect because the market has considerably enlarged to include not only growers and intermediaries but also players with no fundamental stakes either in the growing, consumption or trade and hedging sides.

Inflation is no stranger to the Indian economy. In fact, till the early nineties Indians were used to double-digit inflation and its attendant consequences. But, since the mid-nineties controlling inflation has become a priority for policy framers. As a result, people have become virtually intolerant to inflation. Inflation till the early nineties was primarily caused by domestic factors. Supply usually was unable to meet demand, resulting in the classical definition of inflation of too much money chasing too few goods. Today the situation has changed significantly. It is caused more by global rather than by domestic factors. Naturally, as the Indian economy undergoes structural changes, the causes of domestic inflation too have undergone tectonic changes. However, it is indeed intriguing that the policy response even to this day's complicated causes of inflation, unfortunately has been fixated on the traditional anti-inflation instruments of the pre-liberalisation era.

To understand the present bout of inflation, let us first understand that the global economy is in a state of extreme imbalance. This is simply because developed western economies, particularly the United States, are consuming on a massive scale leading to gargantuan trade deficits. Crucially their extreme levels of consumption and imports are matched by the fetish of the developing countries in having an export-driven economic model. Thus while a set of developing countries produces, exports and also saves (lie proceeds by investing their forex reserves back in these countries, developed countries are consuming both the production and investment originating from the developing countries. In effect, developing countries are building their foreign exchange reserves while the developed countries are accumulating the corresponding debt.

For instance, the high US current account deficit becomes the current account surplus of other exporting countries, viz. China, Japan and other oil producing and exporting countries. The reason for this imbalance in the global economy is the fact that after the Asian currency crisis many countries found the virtues of a weak currency and engaged in 'competitive devaluation.' Under this scenario, many countries simply leveraged their weak currency vis-a-vis the US dollar to gain to gain to the global markets. This mercantilist policy to maintain their competitiveness  Is achieved when their central banks intervenes in the currency markets  leading to accumulation of foreign exchange, notably the US dollar,  against their own currency. Implicitly it means that the developing world is subsidising the rich developed world. In other words, it would mean that the US has outsourced even defending the dollar to these countries, as collapse of the US currency would hurt these countries holding more collars in reserves than perhaps the US itself.

In this connection, the world growth becomes hardly sufficient to Be behind the further rise of commodity prices. Rather than demand   pushing the value of commodities higher, the dollar's devaluation against Commodities pushes commodity prices to record highs. As countries with   huge US dollar reserves fear a fall in the value of the dollar and reach out to various assets and commodities, the prices of these commodities and assets too rise. As the imbalance is not showing any sign of Correction, countries try to shift to commodities and assets across continents to hedge against the impending fall in the US dollar. Thus, it is a light between central banks and the psychology market of players across continents.

As a corrective measure, economists are coming to the conclusion That most of the currencies across the globe are highly undervalued vis- a-vis the dollar, which, in turn, requires a significant dose of devaluation For instance, a consensus exists amongst economists and currency traders that the Yen is one of the most highly undervalued currencies (estimated at around 60%) along with the Chinese Yuan (estimated at 50%) followed by other countries in Asia. This artificial undervaluation of currencies is another fundamental cause for increasing global liquidity.

An analysis of the dollar value of rising prices of crude oil will give Us an idea of the enormity of the aggregation of these two factors on the world’s supply of dollars. In 2004, global demand for crude oil grew by a mere four per cent. Nevertheless higher oil prices advanced by much as 34 per cent. Consequently, it is this factor that significantly contributed to increase the world's dollar supply by about $330 billion. ‘Similarly, in 2005, international crude oil prices gained another 35 per cent and global demand for oil grew by only 1.6 per cent. Nonetheless, (in world's supply of dollars increased by a further $ 460 billion. While one is not sure as to whether the increase in the prices of crude led to the increase of other commodities or vice versa, the fact of the matter is that, in the aggregate, increased liquidity has led to the increase in commodity prices as a whole.

The twin American deficit—current as well as budgetary—remains outside the US. What has further compounded the problem is the near zero interest rate regime in Japan. With almost $ 905 billion fort reserves, it makes sense to borrow in Japan at such low rates and invest elsewhere for higher returns. Obviously, some of this money hi undoubtedly found its way into the asset markets of other countries. Mo of it has been parked in alternative investments such as commodities stocks, real estates and other markets across continents, leveraged many times over. Needless to reiterate, the excessive dollar supply too hi fuelled the property and commodity boom across markets and continent!

So, at a global level, the twin causes—excessive liquidity due ( undervaluation of various currencies (technical) and fear of the US doll collapse leading to increased purchase of various commodities to hedge against a fall in US dollar (psychological)—needs to be tackled upfront if inflation has to be confronted. What actually compounds the problem for India is the fact that lower harvest worldwide, specifically Australia and Brazil, and the overall strength of demand vis-a-vis supp and low stock positions world over, led to the rise in global wheat price The global trends put upward pressure on domestic prices of wheat Hence, it was no wonder when despite the government lowering the import tariffs on wheat to zero, there has been no significant quantity of wheat imports as the international prices of wheat are higher than the domestic prices.

Another cause for the increase in the prices of commodities has been due to the fact that both India and China have been recording excelled growth in recent years. It has to be noted that China and India have a combined population of 2.5 billion people. Given this size < population even a modest $100 increase in the per capita income of the! two countries would translate into approximately $250 billion I additional demand for commodities. This has put an extraordinary high demand on various commodities. Also, the excessive global liquidity he facilitated buoyant growth of money and credit. Crucially, the incremental flow of foreign exchange into the country has resulted I increased credit flow by hanks in India. Naturally this is another fuel for growth and crucially, inflation.

The Reserve Bank of India's strategy of dealing with excessive liquidity through the Market Stabilization Scheme (MSS) has its own limitations. Similarly, the increase in repo rates (to make credit overextension costly) and increase in CRR rates (to restrict excessive money supply) are policy interventions with serious limitations in the Indian context with such huge forex inflows.

To conclude, all these are pointers to a need for a different strategy. I he current bout of inflation is caused by a multiplicity of factors, mostly global and is structural. Monetary as well as trade policy responses, as tins been attempted till date, would be inadequate to deal with the extant issue effectively. Further, the sustained flow of foreign money, thanks in the excessive global liquidity in the world, has fuelled the rise of the stocks markets and real estate prices in India to unprecedented levels. i Ins boom has naturally led to corresponding booms in various related   as much as the increased credit flow has in a way resulted in  overall inflation. Hence, one has to understand that the issues with '' '.peel to inflation cannot be subjected to conventional wisdom in the era of globalization.

One policy route yet unexamined in the Indian context by the government is the exchange rate policy, especially revaluation of the rupee as an instrument to control inflation. A higher Rupee value vis-à-vis the dollar would mean lower purchase price of commodities in rupee terms. The Indian economy has undergone significant changes in the past two decades. With increased linkages to the global economy, it cannot duck the negatives of globalization.