Wholesale price inflation moved to double-digits in March 2010. The wholesale price inflation and food inflation did come down from July 2010. After respite for a few months, inflation went up again in December 2010 and indications are that it will remain at uncomfortable levels for some time. The normal monsoon and expectations of a rebound in agricultural output are not providing the usual dampening effect on prices this time.

In India, inflation is usually triggered by a poor agricultural crop. And the two successive poor kharif (summer) crops in 2008 and 2009 are considered to be behind the current inflationary situation. But then why has the normal crop of this year failed to subdue the rate of inflation?

During the low-inflationary first half of the 2000s, the year 2002–03 stands out. In that year a severe rain shortfall brought down foodgrain production by 18 per cent, leading to a drop in agricultural GDP by 7 per cent. Still, inflation hardly rose in 2002–03 and averaged at about 3–4 per cent, the same as in 2001–02. Why?

The seeming anomaly of low inflation in 2002–03 coinciding with a sharp decline in food output is explained by the fact that the previous year had seen a bumper crop which helped replenish public-sector food stocks sufficiently for the government to intervene effectively to keep prices down. The government released adequate grains through the public distribution system as well as open market sales. By contrast, the monsoon failure in 2009–10 followed a subnormal kharif crop in 2008–09; food stocks with the government at the end of 2008–09, and public release of these stocks in 2008–09 and 2009–10, were lower than in 2002–03. Also in 2002–03, the government kept the procurement price the same as in the previous year, except that a special one-time drought relief of Rp20 for a quintal of paddy and Rp10 for a quintal of wheat were added to the existing price. The drought in 2009–10, in contrast, followed a period of continuous and substantial annual increases in procurement prices since 2006–07. It, therefore, added to the upward pressure on food prices.

The experience of 2002–03 demolishes the thesis that high inflation is inevitable when there is a crop failure. The fact is that the crop failures in 2008–09 and 2009–10 with no absolute decline in agricultural GDP were much less serious than the drop in 2002–03, when there was a huge decline in output. What mattered was the difference in government procurement, pricing and distribution policies between then and now. The main difference, however, is the demand situation and that mattered more.

Since 2002–03, the GDP growth broke all previous records and the economy grew by an average of nearly 9 per cent per annum in the next five years. This implied a rise in per capita income in real terms at nearly 7.5 per cent per annum. During this period the per capita availability of major food crops had been, on the contrary, either stagnating or declining.

Thus, while the flare up in inflation from 2008–09 can be attributed to crop failures, the building up of inflationary pressures since 2006 is due to the rising food demand-supply gap during the period.

As the global crisis hit the world, all countries followed ultra-loose fiscal and monetary policies in 2008 and 2009. The Indian economy recovered from the second quarter of 2009–10, showing an average year-on-year growth of 7.9 per cent in the last three quarters of 2009–10 against an average growth of 6.1 per cent in the previous three quarters. The growth rate picked up further to 8.9 per cent in the first two quarters of 2010–11. As the economy picked up inflation also rose. Food inflation rose to 17.1 per cent during the last three quarters of 2009–10 from 10.8 per cent in the previous three quarters and further up to 18.8 per cent in the first two quarters of 2010–11. Wholesale Price Index (WPI) inflation rose to 4.7 per cent in the last three quarters of 2009–10 and shot up further to 9.9 per cent in the first two quarters of 2010–11.

The Reserve Bank of India (RBI) began its monetary tightening only from mid-February 2010, initially by raising the cash reserve ratio of banks, and the rate tightening began later from mid-March 2010. Since March, the repo rate has been raised seven times, each time by 25 basis points. The very high food inflation (17.1 per cent) and the CPI(Industrial Workers) inflation (13.5 per cent) during the last three quarters of 2009–10 clearly required the RBI to act earlier.

In the short term, the only option available is a harder monetary tightening. It should be difficult to purge out the inflationary expectations that have got entrenched by now. The consequent rise in interest rates is bound to reduce corporate profitability and bring growth down. This is the inevitable cost that has to be incurred for bringing inflation down.

Fundamentally, India is confronting a binding food constraint to its growth beyond the 7–8 per cent rate. To avoid a return to the pre-2000 period of inflation, India has to remove all the constraints against a breakthrough in food production. This requires agricultural reforms. The earlier round of reforms carried out in the 1990s were focused on industry, foreign trade, foreign investment and the financial sector, bypassing agriculture. The next round of reforms that is needed for raising India’s potential growth rate beyond 7–8 per cent should essentially have agriculture as an important component.

The persistence of high inflation is rooted in the inability to raise food production in step with the rise in demand arising from increasing population and per capita income growth. The present ‘subsidy-control regime’ in agriculture is strangling the farmer and preventing him from achieving a breakthrough in production. The input subsidies provided through low or no price for water, electricity and urea fertilisers not only lead to overuse and erosion of soil fertility, but also ensures inefficient production of these inputs by companies. Farmers can sell their products only through government markets which involve a large number of intermediaries and lower prices. Consumer subsidies administered through the public distribution system lead to low food prices which scarcely reach the consumers as large scale leakages take place. On the other hand, the government’s food procurement with periodical hiking of the procurement prices leads to market shortages and rising food prices.

Agricultural reform is the key to controlling inflation. That should involve lifting of government controls on pricing of all inputs and outputs, abolition of the monopsony of government mandis and administering all subsidies through direct cash transfers to poor farmers (owning land below two hectares) and poor consumers (below the poverty line).

Mathew Joseph is a Senior Consultant at the Indian Council for Research and International Economic Relations (ICRIER), New Delhi.