The Sunday Times Economic Analysis

The Sunday Times Economic Analysis By the Economist

Realising the impossible dream: Keeping prices down
Consumer prices continue to rise. The dream of lower prices promised at the last general elections has faded away. It was an impossible dream that people were made to believein – not for the first time. Will such a promise be believed at future elections? Who knows, there may be candidates that can sell the lie? The current reality is that prices have risen, are rising and will continue to rise. Attempts to tame prices are mostly futile exercises.

Promises to reduce prices are a fraud. Prices are determined by a multiplicity of causes and in a country that is highly import-based, what happens outside in the global economy has an important bearing on domestic prices. The increase in prices is due to what economists call "cost push" and "demand pull" factors.

The price increases in imports is a major factor in causing a cost-push, while the overall imbalance in the economy and deficit financing let loose demand-pull factors. In fact the cost-push and demand-pull factors act together to increase the inflation each feeding the other continually.

The recent price increases in petrol and gas were the most striking and conspicuous. Prices of other commodities have also continued to rise. Significant among them is the rise in rice prices. At the end of last month the price of Kekulu and Samba varieties of rice were Rs. 44 and Rs 40 per kilo, respectively. These prices were about 12 and 32 per cent higher than a year ago, when they were about Rs. 39 and Rs 30, respectively. Vegetable prices rose suddenly in the second quarter of the year. However some vegetable prices and other foods, like onions and chillies, appear to have come down in price from that of a year ago. Milk and sugar prices have increased. All consumer price indices show increases though they vary from1 per cent to 6 per cent.

Its easiest to understand price rises in oil based products as the international price of crude oil has risen to as high as US$ 40 per barrel from around US $ 26 per barrel a year ago. We can also explain the increase in prices of imported commodities on the basis of international price increases. Add to that explanation the exchange rate depreciation of the rupee by about 6.5 per cent in the last twelve months. This means that all imports cost more in rupee terms. The retail price increase of imported items would be higher than the rate of depreciation owing to increases in taxes.

What about domestically produced goods? They rise for three reasons. The decrease in production is at the core of this price increase. In addition there is an increase in the cost of their production owing to imported inputs and raw materials. Then the higher costs of living mean additional costs by way of higher wages. People stunned by the sudden price increases are not likely to appreciate the fact that the full impacts of international price increases have not been passed on to them.

The fact that the government is absorbing these price increases is academic to them. The fact that such subsidies will affect the longer term prospects for the economy and that sooner or later price increases would strike them, is of little interest to them at present. The cry is bring down prices or raise wages. But what about the consequence of such action and the fact that it would itself increase the pressures for further price increases. Besides those who are not wage earners would have no relief.

This year is likely to be one of high inflation with consumer prices at much higher levels than in recent years. One cannot blame the government for these trends, but the weak economic effort is only likely to aggravate the situation in the coming months. The weak economic situation and fiscal predicament are not likely to offer any solution. Yet if the inflationary trends continue unabated, the competitive capacity of the economy in international markets is likely to be affected adversely.

Continuous depreciation of the rupee offers a temporary relief to exports, but the inflationary pressures these result in would aggravate the inflationary situation further. This in turn would affect the costs of export items. Most important is the rise in consumer prices that a depreciation of the currency leads to and the political non-sustainability of a government that faces elections in an environment of escalating prices. The external shock of higher international prices is a blow that is difficult for a weak import dependent economy to cope with.

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