In recent weeks the prices of agricultural commodities have risen sharply. The headline WPI inflation has breached the RBI's threshold inflation rate of 5-5.5 per cent for the year. An interesting question is does an increase in headline inflation due to adverse supply shock (unusual weather that affects harvests) automatically translate into higher trend inflation?
This is of interest because it is trend or core inflation that policymakers can, strictly speaking, aim to control. As we shall see in this article, the answer to this depends on how monetary policy responds to shocks.
Let us look at this in more detail. First, we need to understand the distinction between a) relative prices and the general (absolute) price level, and b) between trend and transitory inflation. The general price level, for example, the wholesale price index is a weighted average of all goods in the consumption basket.
In contrast, relative price is the price of a particular good (or service) compared to the price of another good (or service). For instance, an increase in the price of pulses (due to a crop failure, say) is an increase in its relative price vis-à-vis other goods which may or may not influence the general price level.
The intuition is fairly straightforward. In theory, as the prices of pulses rise and if people want to consume the same amount of it as before, the demand for other commodities would have to fall as less money is now available to spend on all other goods. This adjustment would leave the WPI largely unaffected.
To make things clear, let us consider an example of relative price changes in India in recent years. Take two commodities -- foodgrains and textiles. As the figure shows, in the last two years the relative price of textiles to foodgrains has persistently declined. While textile is an internationally traded commodity which is subject to competitive pressure, the same cannot be said about foodgrains.
If there is faster technical progress in traded goods sectors compared to non-traded sectors such as foodgrains, the relative price of textiles would fall. This relative decline in textile prices has in fact coexisted with different (and relatively stable) overall inflation rates. Thus, a stable overall inflation rate is perfectly consistent with volatile individual components of the price index.
However, the real world is characterised by rigidities, that is, prices adjust slowly because of adjustment costs. If so, an increase in the price of pulses, for example, may lead to transitory periods of sharp increases in the general price level -- headline inflation. Nevertheless, it is not clear how relative price shocks can explain an increase in trend inflation, that is, permanently high inflation rate. So what determines trend inflation?
Trend inflation depends on the central bank's policy response to shocks and how policy affects expectations. When agents expect policymakers to accommodate shocks, that is expand money supply (or reduce interest rates) in response to unfavourable shocks, expected inflation is likely to rise.
If inflation is expected to rise, workers demand higher wages to preserve their purchasing power. Since prices that firms charge is a mark-up over wages and other costs, a higher wage bill translates into permanently higher output prices.
Conventional wisdom holds that accommodative policies that expanded the money supply to avoid a oil shock driven recession, were responsible for a good deal of the rise in US inflation during the 1970s. In contrast, if supply shock induced wage-price spirals were not being validated by an expansionary monetary policy, then inflationary impulses as a result of negative supply shocks cannot gain a permanent hold on inflationary expectations. Hence, the central bank's policy response to shocks is the key to understanding trend inflation.
So how should monetary policy respond to supply shocks? A negative supply shock typically shows up as an increase in headline inflation accompanied by a decline in output. Since monetary policymakers in most countries have a dual mandate, they are faced with a difficult choice. If they choose to tighten policy in order to offset the effects of the shock on inflation, they may well succeed -- but only at the cost of a further fall in output.
Likewise, if they choose to ease in order to mitigate the negative effects of the shock on output, their action will exacerbate the inflationary impact, that is, get translated into permanently high inflation. Most central banks choose to do nothing.
The argument for ignoring changes in food and energy prices is that although these prices have substantial effects on the overall index, they often are quickly reversed and so do not elicit a policy response. The optimal response in most cases, therefore, is to accept some temporary rise in inflation and unemployment.
Implicit in the preceding argument is that the policymaker can clearly identify both the nature of shocks and their impact. In practice, however, things are not as clear-cut and hence a lot of judgement is involved.
The foregoing discussion however does not imply that changes in relative prices are irrelevant. In fact, relative prices convey important signals to the market regarding excess demand or supply for a particular commodity.
It is the change in relative prices that enables consumers (and producers) to decide which goods and services to buy (and sell). For instance, when the relative price of oil goes up, consumers tend to cut back on the use of petroleum products and seek alternatives. At the same time, it drives oil producers to increase capacity both via exploration and adoption of new and improved technologies. Thus, changes in relative prices ensure efficient allocation of scarce resources.
In sum, the crucial determinant of inflation is not supply shocks per se but how monetary policy responds to these shocks.
This is not of course to deny that nature (supply failure) may almost inevitably give rise to a temporary bout of inflation. But in the absence of monetary accommodation, the effect of these shocks on inflation will be fairly benign. Inflation therefore is a phenomenon of policy and not of nature.
The writer is an economist with CRISIL. The views are personal.