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Friday, February 02, 2007

Who pays for inflation control?

Hapless milk farmers

Inflation has accelerated sharply and the UPA now truly wants to get a grip on it. Today I saw this news item:

The government on Thursday banned exports of milk products until the end of September, the country's finance minister said.

"Considering the milk situation the cabinet has decided to ban export of milk products till September 30, 2007," Palaniappan Chidambaram told reporters.

Prices of milk products have been rising due to supply shortages. Rising inflation has forced the government to adopt a variety of measures in recent weeks targetting widely consumed items.

I am very happy when a government gets anxious about inflation. I have always been disappointed by RBI statements that (WPI) inflation of 5 to 5.5 percent is acceptable. This is a very high inflation rate, in my book.

But one does have to think carefully about how low inflation might be achieved. I find it useful to think of this situation in terms of the question: Who pays for slowing down inflation?. If low and predictable inflation is a public good, and everyone benefits from lower inflation, it appears unfair that milk producers should have to bear a disproportionate part of the cost of inflation reduction. If someone outside the country is willing to buy milk powder at a price higher than the local price of milk powder, it is not fair for a government to interfere in the transaction and prevent a higher revenue stream reaching the milk powder producer.

Inflation control through monetary policy vs. inflation control through interference in commodity markets

This links up to the debate about how to control inflation. The nicest way to get a grip of inflation is to use monetary policy. Raising interest rates, gently by 25 bps at a time, touches the pockets of borrowers all across the country, pulls in aggregate demand, and gets inflation under control. We need to do more in terms of placing the full and exclusive responsibility for inflation upon a Monetary Authority. It needs to be independent in pursuing an inflation target, and be held accountable for achieving this target.

The incidence of inflation control efforts should be dispersed all across the economy. It is unfair if there is a disproportionate incidence on a few households. Inflation control through monetary policy achieves the former, while inflation control by going after supply side issues - the old Indian way of dealing with inflation - involves the latter.

Should we be skeptical about inflation measures which include food?

It is often argued that food prices should be viewed differently when it comes to inflation and monetary policy, for two reasons: (1) Food prices are inherently volatile and should (in any case) be removed from an overall inflation measure in computing `core inflation'; (2) Food prices are highly distorted by the government. This is one criticism of the CPI - that it has a significant weight of food, while the WPI does not.

On the issue of price volatility, I respect the idea of core inflation, but I would not lose sight of the fact that ultimately inflation is about the GDP deflator, and in a country where food is a big part of the consumption basket, we should tread cautiously in removing food from an inflation measure. The price of food is important in affecting the value of the rupee in the eyes of a lot of households. There is no wishing away that problem.

On the issue of government distortions, I quite agree that on things like wheat, the government is prominent in price formation, and hence these commodities should be removed in thinking about inflation. As an aside, I may add that when there is a hint of inflation in the air, the government does all it can to avoid raising these prices, so removing them from inflation measurement at a time like this will probably yield a higher measured inflation.

My basic point is that the market for milk is actually quite a nice and normal free market. There are millions of atomic producers and millions of atomic buyers, none of whom possess market power. Milk is a sensible part of the market economy (as long as the government doesn't get into banning exports). I see no reason why the ordinary processes of the market economy do not apply for milk where there is little or no government involvement and prices are formed on a competitive market. It may sound cruel, but homeowners with floating rate loans do buy less rasmalai when interest rates drive up their EMI, and that's a perfectly sensible mechanism for monetary transmission from higher interest rates to lowered milk prices.

For an increasing part of the food that's purchased by households, there is little or no government manipulation of the price. This includes milk, eggs, meat, vegetables, fruit, some grain, some oilseeds, etc. These prices are coming out of a nice Walrasian market. When these prices go up, we should interpret this as inflation, and use monetary policy to combat it.

1 comment:

  1. I must agree. I also believe that overheating is a very real concern within the next year. It seems the government wants to have its cake and eat it too with its inflation controlling measures. But what about the supply of milk? Is restricting exports a see-saw policy?
    Also, am a new reader from the States; enjoying your blog.


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