Given the administration’s chronic weaknesses in fixing supply side constraints for tackling food price inflation, RBI had persevered with its “calibrated policy” of monetary tightening – called “baby steps” — to contain inflation which was, however, getting increasingly generalized. The headline inflation was already above RBI’s comfort zone of 5 to 6 per cent with WPI edging close to 9 per cent in March 2011, engulfing the entire range of domestic manufactured goods. More than this, the sharp rise in global commodity prices with an explosive surge in oil prices since the last quarter of 2010 – rising to a peak of 123 dollars a gallon by April 2011 – has drastically altered the dynamics of the global price situation.

The renewed surge in international commodity and oil prices, as in 2008 before the financial meltdown and economic downturn, has started sending shock waves for the global economy already on weak recovery from the Great Recession. Oil prices may have moderated a little below 120 dollars since April but remain volatile still above 100 dollars, amid fears of supply disruption arising out of the conflicts in the Middle East and North Africa or signs of some slowdown in recovery in advanced economies.

The current prognosis is for global oil, food and fertilizer prices to remain high and could increase further, and on this assumption, the imperative of aggregate demand management has been underlined in RBI’s Monetary Policy Statement of May 3, when it raised the key policy rates by 50 basis points reflecting the need for stronger action. But what is more important for influencing aggregate demand , as RBI statement emphasizes, is the pass-through of the higher international oil prices to domestic prices. Otherwise, higher subsidy expenditure could add to inflationary pressures and the increase in fiscal deficit would, according to RBI, counter any moderating trend in aggregate demand.

Subsidy reduction is a critical assumption in the budget which limits fiscal deficit to 4.6 per cent of GDP. The question is whether Government will muster the will to effect a significant pass-through of higher prices for all petroleum products at this point of time, which would immediately give a further push to inflation. The Prime Minister Dr Manmohan Singh had said on the budget that it sought to address inflation without hurting growth. Essentially, he would have had in view the fiscal deficit being lowered to 4.6 per cent of GDP from 5.1 per cent in 2010/11 (RE) based on both a higher level of anticipated revenue and other receipts and some contraction in expenditure so as to limit the inflationary impact of the budget.

What signaled Government’s reckoning with the reality of inflation is the unreserved support extended to RBI’s May 3 policy statement both by the Finance Minister Mr Pranab Mukherjee, who said it was necessary to contain inflation in the context of the volatility of commodity prices, especially oil and food prices in the international market, and by the Planning Commission. The inter-ministerial group on prices headed by Chief Economic Adviser Dr Kaushik Basu, which was addressed by the Governor of RBI Dr. Subbarao, also agrees that lowering inflation is “desirable” to achieve high, sustainable growth.

There is thus consensus on RBI’s baseline projection of real GDP growth in 2011/12 at “around 8 per cent”, though Dr. C. Rangarajan, Chairman of Economic Advisory Council, thinks the economy could grow by 8.5 per cent if inflation is contained at less than 7 per cent, in which case there would not be need for further policy tightening. RBI’s revised projection for WPI is 6 per cent by March 2012, taking into account the current level at around 9 per cent, which could prevail in the first half of the year, and likely decline in the second half of the year to 6 per cent “with an upward bias”. RBI itself is not certain the new WPI target would be feasible, after its inflation-targeting experience in 2010-11.

Mr Mukherjee now looks at inflation management more challenging in the context of volatility in global prices of food and fuel and the possibility of its becoming a long term problem. The Government’s economic agenda of the current year, apart from containing inflation, included reforms in the financial sector and further foreign investment liberalization. It remains to be seen how far Government would be able to get through with oil price deregulation and other pending reforms in a politically surcharged environment. The results of the Assembly elections – chiefly West Bengal, Tamil Nadu and Kerala – to be announced on May 13 have assumed critical importance for UPA-II Government in terms of both political stability and economic space to usher in the promised “new wave of reforms”. At stake is both fiscal consolidation and UPA's credibility for taking reforms forward.

The increase in oil prices also widens the trade and current account deficit though India has so far been financing it with capital flows despite a reduction in direct investment flows. Given the weak recovery in advanced economies, India’s export growth will be significantly lower than the highly impressive 37 per cent in 2010/11, which was over a low base of the previous year. Last year, the current account deficit at 2.5 per cent of GDP could be financed with capital flows though a large part was in volatile category (portfolio investments and short-term credits). Any larger level of C A deficit in the current year would run into financing problem. Overall, there has been a net addition to reserves of 33 billion dollars over a year ending April 29 when the reserves stood at over 313 billion dollars.

A more optimistic assumption could be that growth rises to a little above 8 per cent in the current year, taking into account both the slowdown in industry, especially the capital goods sector, and in investment spending in an uncertain inflationary environment, IMF, which projects 8.2 per cent growth in 2011, expects inflation in many Asian economies to increase further before decelerating modestly in 2012.

While some countries have been raising interest rates, real policy rates are still negative in emerging economies including China, India and Korea, IMF says. Both China and India have now taken up lowering inflation as the over-riding policy objective to achieve sustainable growth over the medium-term. China is willing to go down to a 12th plan average of 7 per cent (2011-15). India, which aims at 9 to 9.5 per cent growth for its twelfth plan (2012-17), is not given to pessimism until outcome proves otherwise. (IPA Service)