I.

Inflation, a global phenomenon

inflation is a rise in the general level of prices of goods and services in
an economy over a period of time. When the general price level rises,
each unit of currency buys fewer goods and services. Consequently,
inflation also reflects an erosion in the purchasing power of money – a
loss of real value in the internal medium of exchange and unit of
account in the economy. A chief measure of price inflation is the
inflation rate, the annualized percentage change in a general price index
(normally the Consumer Price Index) over time.

Inflation's effects on an economy are various and can be simultaneously

positive and negative. Negative effects of inflation include a decrease in
the real value of money and other monetary items over time, uncertainty
over future inflation may discourage investment and savings, and high
inflation may lead to shortages of goods if consumers begin hoarding
out of concern that prices will increase in the future. Positive effects
include ensuring central banks can adjust nominal interest rates
(intended to mitigate recessions), and encouraging investment in non-
monetary capital projects.

Economists generally agree that high rates of inflation and

hyperinflation are caused by an excessive growth of the money supply.
Views on which factors determine low to moderate rates of inflation are
more varied. Low or moderate inflation may be attributed to fluctuations
in real demand for goods and services, or changes in available supplies
such as during scarcities, as well as to growth in the money supply.
However, the consensus view is that a long sustained period of inflation
is caused by money supply growing faster than the rate of economic
growth.

Today, most mainstream economists favor a low, steady rate of

inflation. Low (as opposed to zero or negative) inflation may reduce the
severity of economic recessions by enabling the labor market to adjust
more quickly in a downturn, and reduce the risk that a liquidity trap
prevents monetary policy from stabilizing the economy.The task of
keeping the rate of inflation low and stable is usually given to monetary
authorities. Generally, these monetary authorities are the central banks
that control the size of the money supply through the setting of interest
rates, through open market operations, and through the setting of
banking reserve requirements.

After Subprime, inflation has become the second most dangerous word today.
Globally, economies are struggling to fight this rising menace, which has
started making the situation more complex for the world, already ailing with
credit squeeze, bankruptcies, declining consumer and business confidence, etc.
Inflation figures have shot up in different geographies, which were earlier
thought to be not-so-related.

India has one of the highest inflation rates in the world. Is that a good thing for
the stock market? Everyone we speak to says its obviously good for the stock
market since equities hedge against inflation.

Headline WPI inflation, which moderated in the first half of 2009-10, firmed up
in the second half of the year. It accelerated from 1.5 per cent in October 2009
to 9.9 per cent by March 2010. The deficient south-west monsoon rainfall
accentuated the pressure on food prices. This, combined with the firming up of
global commodity prices from their low levels in early 2009 and incipient
demand side pressures, led to acceleration in the overall inflation rate – both
of the WPI and the CPIs.

The Reserve Bank’s baseline projection of WPI inflation for March 2010 was
8.5 per cent. However, some subsequent developments on both supply and
demand sides pushed up inflation. Enhancement of excise duty and restoration
of the basic customs duty on crude petroleum and petroleum products and the
increase in prices of iron ore and coal had a significant impact on WPI inflation.
In addition, demand side pressures also re-emerged as reflected in the sharp
increase in non-food manufactured products inflation from 0.7 per cent to 4.7
per cent between December 2009 and March 2010.

There have been significant changes in the drivers of inflation in recent

months. First, while there are some signs of seasonal moderation in food
prices, overall food inflation continues at an elevated level. It is likely that
structural shortage of certain agricultural commodities such as pulses, edible
oils and milk could reduce the pace of food price moderation. Second, the
firming up of global commodity prices poses upside risks to inflation. Third, the
Reserve Bank’s industrial outlook survey shows that corporates are
increasingly regaining their pricing power in many sectors. As the recovery
gains further momentum, the demand pressures are expected to accentuate.
Fourth, the Reserve Bank’s quarterly inflation expectations survey for
households indicates that household inflation expectations have remained at
an elevated level.

Going forward, three major uncertainties cloud the outlook for inflation.
First, the prospects of the monsoon in 2010-11 are not yet clear. Second, crude
prices continue to be volatile. Third, there is evidence of demand side
pressures building up. On balance, keeping in view domestic demand-supply
balance and the global trend in commodity prices, the baseline projection for
WPI inflation for March 2011 is placed at 5.5 per cent

It would be the endeavour of the Reserve Bank to ensure price stability and
anchor inflation expectations. In pursuit of these objectives, the Reserve Bank
will continue to monitor an array of measures of inflation, both overall and
disaggregated components, in the context of the evolving macroeconomic
situation to assess the underlying inflationary pressures.

Notwithstanding the current inflation scenario, it is important to recognise

that in the last decade, the average inflation rate, measured both in terms of
WPI and CPI, had moderated to about 5 per cent from the historical trend rate
of about 7.5 per cent. Against this background, the conduct of monetary policy
will continue to condition and contain perception of inflation in the range of
4.0-4.5 per cent. This will be in line with the medium-term objective of 3.0 per
cent inflation consistent with India’s broader integration into the global
economy