Tuesday, September 22, 2009

Monetary policy and Food inflation.

The whole sale price index-based (WPI) inflation has come back to positive line at + 0.12 percent for the week ending on 5 September, mainly on the wake of surging prices of essential commodities.

What is the real significance of this inflation number? It only means that the prices of articles have gone up by 0.12% compared to its prices last year when the year on year inflation stood at 12.42 percent (September 2008). Similarly if we compare the current prices with the prices in 2007, then the price has gone up by 12.54%.

Already discussions have begun in the media on the response of the monetary policy towards positive inflation. On this backdrop it is worthwhile to look at the impact of monetary policy on the current food inflation (positive or negative).

The food inflation today stands around 8% year on year. Though the WPI based inflation was on the negative side over the past several weeks, the food inflation per se was very much on the positive side. With quite erratic monsoons this year, the food inflation is only going to rise over the next few months. Our country needs to address this on top priority. We are still by and large a poor country with crores of people having no sustained access to food, water and sanitation.

With the WPI inflation crossing on to the positive side, there is already a talk on rolling back soft monetary policy in order to stem inflationary pressures. Will hardening of monetary policy stem the surge in prices of food articles?

We must understand here that, the current inflation in food articles is mainly on account of poor supply and not on excessive demand. Though the demand has gone up, the supply of food articles have come down drastically. The situation will only worsen on account of bad monsoon. Monetary policy per se cannot do much to augment the supply. Increasing or decreasing the key interest rates will not get down the food inflation. On the fiscal side, the short term solution is to import food at affordable prices and to distribute this food at affordable prices. Monetary policy can help in doing this in the short run.

In the short run, contrary to conventional theory, following a softer monetary policy will help in stemming the food inflation. A softer monetary policy can act positively in three ways vis-à-vis food inflation:

  1. Lower interest rates owning to softer monetary policy will push spending on food and non food articles. Obviously more money will be spent on non-food articles. There will be more credit flow and more economic activity. In this scenario, more money will be at the hands of more people. More unorganized people are likely to get employment and there will be some trickle down if not complete. Under the inflationary condition caused by supply constraints, more economic activity will at least make food articles more affordable thereby controlling the net impact of surge in food prices. Though food inflation will not be controlled a great deal, at least the net impact of surge in food prices can be controlled by increased affordability. On the other, in the short run, a harder monetary policy will stem economic activity and render people with lower or no wages and make food unaffordable and at the same time push the food prices since the food prices are controlled by supply factors and not by monetary policy.
  2. Softer monetary policy will give incentives for import of food articles. Again, in the short run, it can help in reducing the impact of food inflation.
  3. Since the current food inflation is not controlled by demand and supply of money inside the economy, a softer monetary policy will help in boosting revenue to afford food import.

On the long run, monetary policy will not help in making food more affordable. The government must come up with concrete plans to boost the farm economy, moving into a greener economy will yield rich dividends. Government must come up with clear renewable energy policy, must encourage spending on greener technology and get the energy prices lower and make it affordable. Watershed development and sustainable sanitation programmes must be given an unprecedented fillip.

In conclusion, at the current scenario, hardening the interest rates will only worsen the situation with food inflation and the current monetary policy must not be rolled back. On the long run, protecting the environment and boosting farm economy are the only way ahead if we are seriously thinking about a hunger free nation.

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