Guess what the most important voting issue was in the recent general elections (and, indeed, in the four state elections last year)? According to polls, it was not jobs or governance, but inflation!
It is not surprising to see why. For starters, CPI inflation has averaged 9.5% over the last seven years underpinned by stubbornly high food inflation—averaging 11% over that period. The poor—whose incomes are least indexed—also vote in the largest proportions. So high inflation has often directly translated into reduced purchasing power and—in the absence of adequate savings—consumption. It’s no surprise, therefore, that despite a record harvest last year, rural consumption remained weak. Real rural wages had begun to moderate since 2012, in part because nominal wages began to moderate but surging rural inflation has been the real culprit in pulling down real wages.
Second, sustained food inflation in conjunction with the indexation of MGNREGA wages has contributed to a wage-price spiral in the rural economy that has also spilled over into urban wages.
Finally, it is food and fuel inflation that is largely responsible for shaping household inflation expectations. Econometrically, we find that a 100 bps shock to food prices results in a 50 bps impact increase in inflation expectations that decays only over eight quarters! In contrast, a 100 bps shock to core inflation affects expectations by only 30 bps and decays with two quarters. So, taming food inflation is critical to winning the battle on expectations.
In our view, the government should start by taming cereals inflation. Despite the accumulation of record-buffer stocks over the last two years, cereal inflation has averaged 13%! So, buffer-stocks have clearly lost their “threat value” in taming expectations. Instead, they have only served to take flow out of the open-market and pressure prices. For starters, therefore, stocks need to be used more effectively and pre-emptively to push down cereals inflation—both by procuring less and releasing more.
But accumulation of cereal stocks is, in turn, a function of the minimum support prices (MSPs) the government offers (see chart). Sharp increases in MSPs in recent years have overly-incentivised farmers to produce rice and wheat, and thereby impeded the supply response to other price signals. So, MSPs have both a direct impact on cereals inflatioan and an indirect impact by inhibiting substitution.
The good news is that, after an average increase of 11% over the last seven years, cereal MSPs increased by only 5% in the last year