Inflation - The Core Issue

Inflation has dropped to a 13 month low of 4.3% recently. Not long ago the inflation rate skyrocketed to levels of 6.2% and kept the finance minister frantically trying to bring it down. Inflation – the rise in prices of essential commodities is a factor which has a key role in deciding the fate of incumbents in elections. Nothing works up the electorate so much as inflation. The government often does its part to curtail inflation, often as a knee jerk reaction like banning trading in wheat futures. The uncomfortable fact however is that food prices are rising the world over and inflation is not a problem faced only by India. Can the inflation rate be sustained at levels of 4%? Are the lower levels achieved now merely an aberration? Well, only time will tell. China which has a highly regulated economy has been able to do very little to control inflation. Mexico faces a similar problem. Even in developed economies like UK the consumer price index rose by 2.5% and food prices have gone up by 4.8%. Food inflation in the United States was 3.7%. Inflation is a natural consequence of economic growth and prosperity and is not always a serious problem. However a high rate of inflation, almost invariably leads to a squeeze on economic growth. One factor which has shot up the food prices in the Americas is the increasing use of bio-fuels. A large amount of corn has been diverted from the kitchen to the fuel tanks. It is estimated that 1% of the world’s arable land is being used for bio-fuels and this figure will go up to 3.5%. Brazil already runs a substantial amount of its vehicles on ethanol based fuels. With the bio-fuel technology gaining popularity, a new species – vehicles will start eating away our share of food. This however is not the only reason for spiraling prices. The supply of quality land has been shrinking. Expanding cities in India, which is the most densely populated country in the world, has already devoured large tracts of agricultural land. Higher industrialization and special economic zones have brought in more agricultural land under the ambit of industrial activity. With increasing prosperity people eat more and eat better. More land is required to produce a unit of energy from meat than it is needed to provide than same amount of energy from wheat. Growing consumption of meat thanks to prosperity is an addition to the cocktail of factors. Add the vagaries of monsoon to this, and we have a perfect recipe. All this boils down to a core issue – the rise in food prices will continue to be a knotty problem. Concerns of inflation shoot up, always, if it is concerned with food prices. People are less anguished by the rice in car prices than by the rise in the price of potatoes. This in turn would lead to a demand for higher wages and start a chain reaction. A pertinent question stares at us now. What if there is consistent food inflation? Ricardo, the 19th century English economist, famously predicted that as demand for food rose, so would prices. This was simply because less fertile land would be brought under cultivation so the costs of production would rise; this is diminishing returns. Ricardo further said that a stage is inevitable when the rise in food prices would affect profits to such a level that economic growth is strangled. This however has never happened in the past as the world in general and more specifically India was leapfrogging in agricultural advancements. The green revolution brought Indian agriculture back on its feet. Also, more land was consistently brought under cultivation. The supply of arable land today is shrinking. So what is the solution to the inflation conundrum? All that has been done so far are only short term solutions and a proactive agricultural policy is the need of the hour. There is a definite need to bulk up agricultural production in India. Reforms are needed to improve productivity and competitiveness of the farmer. One of the main problems faced today is that of rural micro credit. Probably the only successful model for micro financing was the model of the Grameen Bank in Bangladesh. There is a need to improve the credit system in India. Ensuring monetary supply is one of the key factors. The World Bank in a recent study has said that agricultural trade reforms are vital to reduce poverty in developing economies. Developing countries have been improving agricultural productivity, but the impact of these gains on poverty reduction will not be fully realized unless richer countries reduce their agricultural trade protection. Without such liberalization, increased productivity will lead to overproduction and price declines for many commodities. On the other hand a liberalized free market would lead to resource reallocation. Agricultural trade liberalization would create winners and losers. As an effect of the resource reallocation there would be substantial effects. For example, production of groundnut products in India would likely contract as would vegetable oil production in China, but dairy production and exports would expand in India, and rice production and exports would expand in China. Liberalization of value-added activities is crucial for expanding employment and income opportunities beyond the farm gate. Other winners and losers would also emerge. Multilateral trade liberalization erodes the benefits from preferential bilateral trade agreements and pits low-cost producers in some developing countries (such as sugar producers in Brazil and Thailand) against less efficient producers in the least-developed countries who are currently helped by preferential access. Agricultural reforms have been unduly delayed in India, but policy makers seem to have realized the urgent need lately and we can expect to see affirmative action in these areas. Till then it will be worth watching how food prices affect inflation and profits.