I have wanted to carry out this analysis for a long time now and the criticism of a lot of people that I do not understand economics and I need to go back to school to learn the subject has prompted me to write this article.

As I went about analyzing the data I became more and more convinced about the inability of RBI in controlling inflation as measured in India today via the Wholesale Price Index. I have argued many times in the past also that RBI’s policies are good for controlling asset bubbles. However given the fact that India is very small part of the global economy and the inflation as we see today is largely driven by high food and global commodity prices there is very little the RBI can do in an atmosphere where there is an extremely loose monetary policy in most major economies. Despite the growth outlook globally being weak we have seen that commodity prices have held on (till now at least) due to widespread speculative activity. However not taking that point forward I will now analyze the composition of Indian WPI inflation and the contribution of various segments in the 9.2% inflation of July and show that RBI’s inflation bogey is not going to be controlled by monetary policy. Only a supply response or a correction in global commodities will bring inflation down and the huge monetary tightening that the RBI has done will only slowdown growth, destroy corporate balance sheets and could create a period of at least two years of slow growth.

Now I will proceed step by step. (pardon me for a slightly long article)

The overall inflation for the period ended July 2011 was 9.2%. The first category to be analyzed is the Primary Articles that constitute 20.11% of the WPI and had an inflation of  11.3% for the said period and contributed 2.65% to the overall WPI Inflation. Now primary articles include Food and Non Food products.

Food articles – This category carries a weight age of 14.33% in the Indian WPI basket. Food inflation for the 12 month period ended July 2011 was 8.2%. Now the basket of food products comprises Food grains (4.1% weight age), Fruits & Vegetables (3.84%), Egg Meat and Fish (2.41%) as the major categories. Now no one can argue that monetary policy will have any impact on the prices of these products that are largely driven by a steady growth in domestic demand, both due to an increasing population and improving prosperity that is improving the food basket. The only way Food inflation can be brought down is by increasing supplies (that infact have been good for the last two years) and reducing wastage. Although incrementally there have been improvements in storage and transportation there is still a long way to go. Moreover with Minimum Support Prices moving up every year and input prices also moving up it is highly unlikely that we will see food inflation move down structurally in India in the near term. Cyclical improvements will be there which policy makers will propound as structural improvements. Food inflation contributed 1.17% to the overall inflation for the period ended July 2011.

Non Food articles – This category carries a weightage of  just 4.25%, however the inflation in this category for the period ended July 2011 was 15.5%. This category includes products like Natural and Man made Fibres, Oil seeds, Tannery products, Sugarcane, Rubber, Tobacco, Flowers, and Minerals both metallic and non metallic and Crude Petroleum. Now any person who looks at these products will immediately see that these products are either agri products or global commodities whose prices will not be determined by monetary policy. The non Food article category contributed 0.65% to the overall inflation despite a very low weightage.

The Fuel and Power category has a weightage of 14.91% in the overall WPI inflation basket. This category had an inflation of 12.04% for the period ended July and contributed 1.8% to the overall inflation. This category is divided into

Mineral Oils – This has a weightage of 9.36% and constitutes products like LPG, Petrol, Diesel, Aircraft Turbine Fuel etc. The inflation in this category was 15.36% and contributed a whopping 1.43% to the overall inflation of 9.2%. RBI’s monetary policy has absolutely no role in any way in controlling the inflation of this category driven by global prices and government decisions on fuel price increases.

Coal and Electricity – These two constitute the majority of the remaining part of the Fuel and Power category with a combined weightage of 5.47%. Coal prices moved up from March as the government took a decision to increase prices in March of the current year and as such coal price inflation at this point of time stands at around 15%. Electricity prices have been stable vis a vis last year and have not contributed to the inflation. As such these two combined have not contributed much to the overall inflation.

As such on an overall basis the above categories have contributed around 3.6% to the overall inflation of 9.2%. As such around 5.6% is contributed by manufactured products that have a weightage of  64.97% in the WPI. Now the inflation of this category is given as the primary reason by the RBI in increasing policy rates and tightening policy. This is a big bogey which will become evident as you go through the following paragraphs.

The overall manufacturing products inflation for the period ended July 2011 was 7.49%. Now let us break it up into various categories.

Food Products – Food products have a weightage of 9.97% and include Diary products like Milk, Ghee, Butter, Ice-cream etc, canned food, Maida, Atta, Sooji, Bakery products, sugar, gur, edible oils, oil cakes, tea, coffee, salt, spices, pickles, papad, Readymade food products etc. as the major products. Now howsoever much I might think I find it very difficult to believe that monetary policy can impact the prices of these products in any major manner. Most of these products are priced depending on input prices which are largely commodity. Now one might argue that if people are squeezed very hard and the RBI forces the economy to hard land then some of the primary inflation might not be passed on by the manufacturers of these products. However the reality is that even in that case the impact will be minor. The consumption of these products only has to grow as India becomes prosperous. However if supply of milk, food grains, tea, coffee etc increase then prices will come down of their own. The price of milk as an example was subdued right through the last high growth phase of the economy. However given that every year consumption is rising and supply has not kept up the prices have increased substantially. However in products like sugar, atta, maida etc where supply has gone up prices have come down despite increasing consumption. Food product inflation was inline with the overall manufacturing inflation at 7.55% and contributed 0.75% to the overall WPI inflation.

Beverages, Tobacco and Tobacco products – Weightage 1.76%, inflation 11.25%, no impact of RBI monetary policy. Prices of these products have largely moved up due to increased taxes at both the central and stage levels.

Textiles – Weightage 7.32%. Textiles includes both natural and man made fibres and includes products like Cotton Yarn, Cotton Fabric (various cloth, bed sheets, hosiery products etc.), Polyester Yarn, Viscose Staple Fibre, Nylon Yarn, Mixed products, Woolen products like carpets & shawls, blankets, sweaters, jute products, shirts, mats, undergarments etc. The main reason for the increase in prices of these products was the runaway rise in cotton prices to the magnitude of nearly 150% from March 2010 to March 2011. Subsequently cotton prices have nearly halved. As cotton yarn prices move up normally VSF and other man made product price also move up as there is a degree of replacability. Now if we analyze deeply the increase in yarn and fabric prices has been directly as a result of higher cotton prices. As these prices have corrected we will see the impact on yarn and fabrics also flow through over the next few months. Whereas the overall inflation in textiles has been 12.87% the inflation for cotton textiles has been 22% and that of manmade has been around 8%. How will monetary policy bring these prices down. Prices went up as cotton shot up and will similarly come down. One can argue that if demand is suppressed then the ability to pass it on via the garments and ready product route to end customers will come down. That is possible to some extent, however given that most of the composition of this category has global pricing linkages there is little role of Indian monetary policy. Textiles contributed 0.94% to the overall inflation of 9.2%. Given that there is likely to be a record cotton crop globally and man made fibre capacities have gone up it is unlikely that we will have very high textile inflation next year.

Paper and paper products, Weightage 2.03%, inflation 7.29%. Again largely global commodity price linked. Products include various kind of paper, cartons, cardboard, books and journals, newspaper etc.

Rubber and plastic products, Weightage 2.98%, inflation 7.68%. Products include tyres and tubes whose prices are linked to input prices of rubber and carbon black that have shot up sharply, Plastic products include plastic pipes, components, plastic films, tooth brush, plastic bottles, syringe, polyester films, polymer sacks and other rubber products. This category does have some products where demand will get impacted as the economy slows and as such primary cost pass through might become difficult. This is true of products like tyres and tubes, consumer plastic products etc. However some products like polyester films, PVC pipes etc have a direct linkage to input prices without huge value addition. For this category we can still argue that monetary policy has an impact.

Chemical and chemical products – Weightage 12.01% Inflation 7.94%.  This category includes basis inorganic chemicals like acids, caustic soda, soda ash, lime, alumina, titanium dioxide, hydrogen peroxide, ammonia, chlorine, hydrogen, fatty acids, aromatic chemicals, other organic chemicals etc.  If we look at all these products the one thing that is clear is that most of these are global commodity products where Indian prices largely follow global trends. The other thing is that most of them are related to crude oil prices in one way or the other. As such monetary policy can do little to impact their prices. The other major component of this category are Fertilizer and Pesticides. Now fertilizer prices in India did not move up at all for nearly two years. After pricing deregulation prices have moved up and we have seen that Fertilizers that have a weightage of 2.66% are now seeing an inflation of nearly 10%. However these prices are moving up as a result of change in policy and totally delinked to demand compression due to monetary policy. Pesticide prices have been stable.

Other products in this category include paints and varnishes, dyes, drugs and medicines, perfumes, cosmetics, toiletries. Also it includes, products like thermocol, polymers, petrochemical intermediaries, rubber chemicals, explosives, agarbattis, additives etc among others. Now in this category there is a mix of industrial and consumer products. However here again on the industrial side most products are globally priced commodity products. Among the consumer products also most except maybe products like paints, varnishes etc will not get impacted in terms of demand by monetary policy action. Interest rates hikes will neither reduce consumption or prices. However reduction in rubber, palm oil, crude oil prices etc will have a moderating impact on the prices of these products. Chemical and chemical products contributed 0.95% to overall inflation.

Basic Metals, alloys and metal products – Weightage 10.75%, Inflation 10.05%. This category includes products like iron and steel, castings and forgings, ferro alloys, aluminum, copper, zinc, gold, silver, nuts and bolts, steel structures, cylinders, furniture’s and fixtures, metal containers, pressure cookers, chains and locks etc. The maximum weightage is to ferrous metals that have an 8.06% weightage. All ferrous metal products are globally linked and follow global prices with a lead or lag. Other metals like aluminum, copper, silver, gold etc also follow global prices. Except for a very few consumer products like pressure cookers, locks etc most of these are globally linked commodity products. Under the circumstances there can be no impact of monetary policy on the inflation of this category that has contributed 1.08% to the overall WPI inflation.

Machinery and machine tools – Weightage 8.93%, Inflation 2.7%. Now we finally come to a category where monetary policy has an impact of compressing demand and as such controlling the price increases of these products. Here we already see an impact with inflation at just 2.7%. This category includes agricultural machinery, industrial machinery, cranes, lifts, fasteners, plastic machinery, loaders, machine tools, airconditoners, refrigerators, chillers, engines, earth moving equipment, pumps, batteries, switches, and transformers. Watches, sewing machines, generators, wires, cables, lamps, fans, washing machines, TV, CD Players, computers, dish antenna etc. In this category of products monetary policy has slowed growth and has also impacted price pass throughs.

Transport Equipment and parts – Weightage 5.21%, Inflation 2.8%. Another category where monetary policy works and has compressed demand and pricing power of producers. Companies have also become efficient and held margins to a great extent. Products include various automobiles and their parts, railway equipment etc.


In conclusion I would like to say that my analysis clearly points out that not more than 25% of the overall WPI basket is impacted by RBI’s monetary policy. The increase in rates by the RBI has only managed to slow down growth and led to balance sheet issues with more leveraged corporates. The same policy mistakes are being made that were made in the year 2008 where despite signs of a global crisis RBI kept on tightening and removing liquidity before having to do a volte face in a matter of months. Most other central banks like those of Korea, Turkey, and Australia to name a few have held rates over the last few weeks citing global concerns. The last hike by China was a few months back. Under the circumstances no one should be under the illusion that it will be monetary policy that will bring inflation down. It will in fact be the impending global slowdown and the base affect. For example, on the 1st of January 2011 the Food price index was at 196.5, as per the latest data of 6th August 2011 it is at 191.9. As such there has been no food price inflation since the beginning of the year. Similarly the primary articles index on 1st of January was 197.5 and on 6th August it was exactly the same at 197.5.

Now taking the argument to the other side, I do not in any way want to say that monetary policy does not have an effect on inflation. However in a globalized economy where countries comprising the top 50% of World GDP are actually printing money or pursuing extremely loose monetary policies there is no way we can control global inflationary pressures due to Indian rate hikes. The second point is that the whole concept of targeting WPI is flawed and the inflation targeting should be on CPI that should comprise the current consumption basket and include things like rents, transportation costs and other services that form a big part of the current consumption basket. Moreover policy makers also need to realize that as per established economic theory there is a lag in monetary transmission and even if they actually believe that they can bring down inflation, they need to give the previous actions enough time to have an effect.

Given good monsoons and the global slowdown that is underway the probability is high that these indices might soften further over the next couple of months. As such there is a reasonable chance that we might have food and primary articles inflation at zero to 2% by the end of the year. The question we have to ask is, whether it is due to the tight monetary policy.

I don’t buy RBI’s bogey on its ability to control WPI inflation and neither should you.

P.S As I was just about to finish writing this article the minutes of the last RBI rate setting meeting were released where a majority seemed to be in favor of holding rates.

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