Inflation: As Simple As It Gets

“Onions have become so expensive!”

If you live in India, you have probably heard at least someone around you mutter this phrase before. Ironically, you are less likely to ever hear anyone complaining about vegetables and fruits becoming cheaper. These fluctuations in prices are very common and can have multiple causes. A drought (i.e. a negative supply-side shock) will raise prices while a lower demand for these goods will lower prices. 

While the above quote exemplifies the inflated value of onions, by itself, this doesn’t imply that there is inflation in the economy. Inflation means that the general price level (not just the price of one good or service but everything at the same time) as measured by the cost of a consumer basket is rising. The next relevant question would be what constitutes a consumer basket. The simplest interpretation of a consumer basket is a fixed list of items which would be consumed by an average person. This includes food, beverages, housing expenses, and recreational costs among others. 

It is worthwhile to note that there are different ways to measure inflation. The ‘Consumer Price Index (CPI)’ looks at the basket of consumer goods and services and measures the change in price of this basket over a period of time. The ‘Wholesale Price Index (WPI)’ looks at a basket of wholesale goods (goods purchased in large quantities by businesses directly from manufacturers with the intent of reselling them to retailers). This was the most widely used inflation measure for policy purposes in India until 2014 which was then changed to the CPI by Dr Raghuram Rajan, the then Governor of the Reserve Bank of India (RBI).

While the goods and services in the CPI and WPI basket may be similar, the main difference is that the WPI looks at items sold in bulk between businesses whereas the CPI looks at retail items. Thus, it is not unusual to see a divergence between the two. In fact, in September 2019, the CPI increased from 3.28 to 3.99 (percentage points) while the WPI fell from 1.03 to 0.33 (percentage points). This was considered to be due to a change in the prices of fuel and manufactured goods.

Interestingly, this brings us to another important issue. Items such as fuel and food prices are extremely volatile. Food prices can be particularly unstable as they are dependent on external factors such as weather and supply chain players. So, looking at the CPI might give us a wrong impression about the health of the economy. One way to overcome this issue is by looking at the ‘core inflation’ which is defined as the CPI minus volatile items such as food and energy prices. Core inflation serves as a much better signal of economic health and is widely preferred by policy makers and investors. Another term one might bump into is ‘headline inflation’. This refers to an inflation index measure that most countries focus on and which includes food and energy prices. Since 2014, the headline measure for India has been CPI prior to which it was WPI. 

What causes inflation?

The cause of changes in the general price level is essential to understanding the mechanism of the economy. An increase in price levels, for instance, can be due to supply-side uncertainties (ex. increase in energy prices) or due to higher demand. Higher demand born out of the improving purchasing power of consumers signals economic growth in the future, while a higher energy price might have a converse effect on the economy. 

In the short-run, inflation can be triggered by excessive demand. If everyone suddenly wants hand sanitisers, the price of hand sanitisers will certainly go up, mainly, because it takes time to produce these goods in line with this new higher demand. Cost-push inflation, on the other hand, happens when the cost of producing these goods and services becomes higher and the supplier passes on the burden to the consumer. Popular example of cost-push inflation is higher raw material cost like that of oil, gas and coal. So, if there is inflation just because energy prices have been on a rise, then it is not going to help the economy grow sustainably in the long run. Thus, identifying this distinction is important for the policy makers as the ideal policy could benefit or undermine the economic prospects depending on the underlying source of the inflation. 

What we really want for a healthy economy is a moderate level of inflation rate. We can get it with demand-pull inflation since this will actually lead to more production and higher levels of economic activity. It sends the signal that there is opportunity (excess demand) for the producers to produce more, employ more people and demand more raw materials. Thus, it creates the need to invest in infrastructure and businesses today.  This in turn, will result in a rise in GDP, enabling you and I to witness a future with better living standards. 

There is yet another important way that the authorities study these price shocks. Inflation caused by economy-wide shocks (also called common shocks) brings about a change in the general price level. On decomposition, this is also referred to as the cyclical component of inflation since the pattern of price follows the movement of the economy (business cycles). On the other hand, price changes can be restricted to a specific industry and are commonly referred to known as idiosyncratic shocks. These do not follow the movement of the economy and are considered to be the acyclical component of inflation, since they have no bearing on business cycles. Essentially, policymaker’s responses to changes in general prices caused by a recession vs idiosyncratic shocks such as an oil shock would be starkly different.

Monetary Policy Committee (MPC)

In times of slow growth, the central bank has an obligation to create policies that propel the economy. Typically, this is done by decreasing interest rates to spur investment and creating an environment for productive economic activities. Also known as the ‘Aggregate Demand channel’, these are some ways in which the Central Bank is trying to boost demand in the economy.

On August 6, 2020, the Monetary Policy Committee (MPC) of the RBI met to discuss the current bleak economic situation due to COVID-19. The pandemic and the subsequent lockdown in India have led to massive slowdown of the economy amplified by supply chain disruptions. Since the beginning of this year, the RBI has engaged in expansionary monetary policy such as interest rate cuts of the order of 115 basis points (~1.15 percentage points) to kick start the economy. While another rate cut would most likely facilitate growth in the coming time, the concern stems from inflation. 

The official announcement of the June inflation rate of 6.09% caused a flurry, since it lay above the RBI’s medium rate inflation target which is 4% - 6%. The challenge lies in the fact that rate cuts which enable people to borrow more, also enable them to spend more. And as we just discussed, excess demand can cause even higher inflation. But the devil’s advocate would recommend looking at the composition and identifying the cause for this high inflation.

If the core inflation is not significantly above its recommended target, then we know that the inflation stems from a volatile source. Then, the volatility of the source suggests that prices might return to normal within a short duration, decreasing any concern for future inflation. Further, evidence of overall low aggregate demand could be a signal of an economic slump in which case a policy cut would not just be beneficial but might be necessary.

The MPC, ultimately, decided not to cut the policy rates which are currently at 4%. On an average, monetary policy can take at least 2 years to have an impact on the economy. So, it could be that the RBI is just waiting for the effects of the previous rate cuts to take effect. They have, instead, announced a series of measures to promote credit growth and debt restructuring. For example, they are relaxing lending norms by allowing people to borrow against 90% of their gold assets instead of the 75% that was previously offered. They have also offered a one time opportunity for individuals and businesses to restructure their loans thereby shouldering some of the debts of the economy. 

Let’s hope that all these facilitate fast growth of the economy. Moreover, we hope that the next time you notice an increase in onion prices, you will stop to consider the causes and be better informed about its economic implications for you.