Spikes in food and fuel prices in 2008 caused inflation rates to increase in most Asian countries. With the onset of the global financial crisis in 2008-09, however, price pressures subsided rapidly across the region except in South Asia. Indeed, India and Pakistan are experiencing double-digit inflation driven mainly by food.
Given the high incidence of poverty in the region, higher food and overall inflation rates disproportionately affect the poor. Moreover, because of the large share of food in the average household consumption budget, a sustained rise in food prices tends to put upward pressure on wages and, with a time lag, on general inflation.
An analytical and empirical examination of the causative factors of inflation can be divided broadly into two categories: demand and supply. The analysis shows that demand components have tended to fluctuate with output levels and growth rates but they have not been major independent sources of price shocks. The major sources of price volatility have been from the supply side.
Although longer-run aggregate supply in South Asian countries is elastic given youthful populations in transition to more productive occupations, it is subject to frequent negative supply shocks. Demand contractions tend to amplify these shocks. South Asian economies are supply constrained in the sense that while output is largely determined by demand, inefficiencies on the supply side tend to perpetuate inflation by creating shortages of goods and services from time to time.
Food price-wage cycle
With a supply shock, the aggregate supply curve in the figure shifts upward, leading to higher inflation. If, in response, a demand contraction shifts the aggregate demand curve downward, this reduces inflation only marginally and at a high cost in terms of output lost. Therefore, the use of restrictive demand-side policies to tackle inflation when its causes are primarily on the supply side may not help much in reducing overall inflationary pressures. Both formal econometric tests and analysis of shock episodes based on Indian data support this analysis.
In South Asia the food price-wage cycle is an important mechanism for propagating price shocks and creating inflationary expectations in response to a supply shock, which acts as an inflation trigger. The political economy of farm price support, consumption subsidies and wage support, with built-in waste, inefficiencies and corruption, contributes to chronic cost-push pressures. Poor targeting of consumption subsidies implies nominal wages rising with a time lag, pushing up costs and generating second-round inflationary pressures from a temporary supply shock.
The political economy of the sub-region informally indexes wages with food price inflation. If the rise in average wages exceeds that of agricultural productivity, however, prices of food will inevitably go up, propagating more generalised inflation. Populist policies that provide short-term subsidies but raise indirect costs also contribute to cost-push pressures. For example, neglected infrastructure and poor public services increase overall costs in the economy. The power shortages from which most South Asian countries suffer are a case in point.
Virtually all countries in the sub-region have shifted to more flexible exchange rates that are managed to varying degrees. Bangladesh and Sri Lanka avoided significant exchange rate depreciation during the global crisis and their inflation rates dropped into the low single digits in 2009. Elsewhere, however, food inflation has remained high. These differential outcomes indicate a more strategic use of exchange rates in anti-inflation policy.
Once the nature and structure of shocks and elasticities of aggregate demand and supply are identified, certain policy implications follow: a shift down the supply curve in response to a supply shock; avoidance of an excessively large demand contraction; and the identification and removal of propagation mechanisms. Above all, a hasty tightening of monetary policy will, in all likelihood, involve a large output cost with little effect on inflation.
Policy options
Mild but early monetary tightening after a supply shock can prevent inflationary wage expectations from becoming entrenched and further pushing up the supply curve. Given this, a first-round price increase from a supply shock might be allowed, but a second-round wage-price increase should be prevented inasmuch as possible. A nominal appreciation of the exchange rate can serve to push down the supply curve.
Short-term fiscal policies to push down the supply curve include tax and tariff cuts and freer imports. These policies can also lower inflationary expectations. Trade policy works best for individual country shocks that are not globally correlated. Nimble private trade can defeat speculative hoarders. It should be stressed that short-run policies are likely to work only for a temporary shock. A long-lasting shock requires a longer-term productivity response.
Food prices play a central role in propagation mechanisms since they raise nominal wages with a time lag. A fundamental reason for chronic supply-side inflation is that real wages tend to exceed labour productivity. The solution is to raise labour productivity, especially in agriculture.
Following liberalisation, as farm produce has become part of the wider traded economy, global prices have begun to affect domestic food prices. In such a situation, the exchange rate can affect food prices and overall inflation. Conflict between a depreciated exchange rate to encourage exports and an appreciated exchange rate to increase real wages can contribute to a wage-price cycle, with depreciation raising nominal wages and prices and leading to real appreciation. Attempts to dampen exchange rate appreciation sustain the cycle. Only improvements in productivity can close the demand-supply gap and break this inflation propagation mechanism.
Capital inflows will tend to appreciate the exchange rate, thus satisfying the wage target, and finance the accompanying rise in imports. But a widening current account deficit is risky even though it might allow gross investment to exceed domestic savings. It would be preferable to set a sustainable current account deficit and meet it by raising productivity in the economy. Rising productivity increases the level of capital inflows that can be safely absorbed at a reasonable current account deficit. In this regard, better governance and improved delivery of public services improve productivity in the economy and, within the corpus of governance, reform of food policy is especially urgent given the economy-wide impact of food inflation.
Governance in food policy
Developing East Asian countries with large food components in household budgets have successfully moderated food inflation by focusing on raising agricultural productivity. India moved early to agricultural subsidies together with implicit taxes generated through the imposition of restrictions on different activities within the agricultural sector, including public distribution schemes.
Procurement prices were raised with the rise in border prices but did not fall with them, thus imparting generalised cost-push pressures in the economy and creating unnecessarily large food stocks in costly and dysfunctional food support programmes. If the procurement price becomes a true support price, food stocks should come down in a bad agricultural season when market prices rise and go up as market prices fall in a good year. Through such a policy, farmers would receive some assured income support even as a removal of restrictions on the movement and marketing of agricultural goods and better infrastructure allowed them to diversify their crops.
With lower average stocks, the public distribution scheme should focus more on remote, inaccessible areas. Food coupons or cash transfers directed primarily to female members of households can provide food security to the poor while allowing them to diversify their food consumption basket. Since the income elasticity of demand for food is still high, more moderate nominal price increases could serve to incentivize higher agricultural output and income growth.
Political jostling when deciding on food policy, in general, and procurement prices, in particular, ignores their negative long-term effects. Poor coordination means that multiple agencies do not factor in each other's costs or consider the wider picture. Until thorough food policy reform occurs, a possible nominal appreciation of the nominal exchange rate can prevent a sharp rise in border prices from triggering multiple interest group actions resulting in complex domestic distortions.
Managing supply shocks
Emerging markets must find non-distortionary ways to respond to spikes in food and commodity prices. Large global spikes imply distortions beyond supply shocks, which should be prevented. Policies that are driving up prices across all asset categories such as excessive liquidity creation in some of the developed countries that is directing large funds into commodities, might be re-examined at a sub-regional or regional level and its impact modified through some form of collective action.
Futures markets help output planning through better information on future demand and supply and the hedging of risk, but any overreaction implies that prices in financial markets do not reflect their real determinants. The answer is not to ban such markets but to improve their working and regulation. Progressive convergence towards common global regulatory standards can prevent arbitrage. Participation by more diverse groups in commodity trading could be encouraged within a framework of rules that discourage market abuses and thereby limit volatility.
