Duvvuri Subbarao: The challenge of food inflation
Presidential address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
25th Annual Conference of the Indian Society of Agricultural Marketing, Hyderabad,
22 November 2011.
* * *
1. First of all, my thanks to the Indian Society of Agricultural Marketing, particularly to
Prof. Radhakrishna, the President, and Prof. Satyanarayana, Secretary of the Society for
inviting me to address this conference. Speaking to a gathering of distinguished agricultural
economists is an opportunity to which I attach a lot of value. Whenever I am invited to speak,
I struggle to determine a topic that is relevant to the organizers, and is also within the domain
of the Reserve Bank. In this instance though, I did not have any problem since there is a vast
subject area that is of mutual interest to the Reserve Bank and to agricultural economists,
particularly economists with sub-specialization in agricultural marketing. For today, I have
chosen to speak on the challenge of food inflation.
I. The context
2. Persistent and elevated food inflation over the last few years has emerged as a
major policy concern, especially as it can potentially threaten our collective aspiration for a
"higher, inclusive and sustainable" growth. Intriguingly, we are experiencing high food
inflation in the face of record production of food grains, robust buffer stocks and growing
resilience of agriculture to monsoon uncertainties. Evidently, the dynamics of food inflation
have changed significantly, and understanding them is obviously important for a policy
response.
3. A related question that has engaged economists has been the role, if any, of the
central bank in combating food inflation. Opinion on this has spanned the entire spectrum. At
one end is the view that monetary policy should be the "first line of defence" no matter what
the drivers of inflation. At the other end is the view that monetary policy is an inappropriate
instrumentality to address supply pressures, and that the central bank should adopt a "hands
off" approach. Real world, as we know, is too complex for such binary text book
prescriptions; management of food inflation has always been a complex challenge for the
Reserve Bank, both by way of policy action and its communication.
4. What I propose to do in this address is to first highlight the trends in food inflation
over the past 60 years. Having thus set the context, I will turn to factors driving structural
food inflation, which should give us a perspective of the underlying dynamics and the nature
of the challenge. I will then move on to indicating the policy measures for addressing the
challenge of food inflation on a durable basis. I will, in the end, address an issue more
directly relevant to the Reserve Bank - the role of monetary policy in the face of supply
shocks.
II. Trends in food inflation over last six decades
5. An assessment of the inflation trends over last six decades indicates that India has
encountered successive bouts of high food inflation, but the underlying drivers have changed
over time; the influence of monsoon has declined and some new sources of price pressures
have emerged. What is particularly notable is that during the 2000s, average food inflation
fell significantly (Chart-1). In contrast, since 2008-09 (i.e. about last three and half years),
average food inflation has been higher than the average food inflation in each of the past six
decades. This cannot all be attributed to poor monsoon. Sure, rainfall was deficient in 2009,
but so was it in 2002 and 2004. But, in the earlier years, food inflation remained modest, at
less than three per cent over three successive years during 2002-05 whereas it shot up to
double digits in 2009.What has changed in recent years to cause sustained price pressures?
This is the big question we need to answer to find a durable solution to food inflation.
III. Factors driving food price pressures
6. What are the factors driving food inflation? I would emphasize the following: (i) shift
in dietary habits towards protein foods; (ii) pressure stemming from inclusive growth policies;
(iii) large increases in MSPs of foodgrains; (iv) shocks from global food inflation; and
(v) financialisation of commodities. Let me take them up one by one.
(i) Shift in dietary habits towards protein foods
7. A distinct feature of recent food price inflation has been the sustained price pressure
in protein rich items (pulses, milk, fish, meat and eggs). Inflation in protein rich items has
generally exceeded both headline (WPI) inflation and inflation in primary food articles
(Chart-2).
8. As one would expect, the share of food in total expenditure has declined over
successive rounds of NSSO surveys alongside increases in per capita income, consistent
with Engel's Law (Chart-3).
9. We need to turn to the lesser known Bennet's Law for an explanation of food
inflation. Bennet's Law suggests that as incomes increase, the proportion of starchy staples
in the food basket declines relative to the share of more expensive sources of calories.
Recent NSSO data showing a significant increase in the share of protein rich items in total
food expenditure, both in rural and urban areas, confirm this hypothesis (Chart-4). Though
protein inflation, reflecting changing dietary habits, was evident earlier as well, the pace of
increase has been sharperin recent years reflecting, in part, accelerated increases in nominal
wages.
10. Even in the face of such structural changes in dietary habits, inflation is not
inevitable. The reason structural changes have triggered inflation in India is that the supply
response in respect of most protein items has not been adequate. With the exception of
pulses, other protein rich items are not crop products. This is an important point since it
explains the growing disconnect between the performance of agriculture and the trajectory of
food inflation.
(ii) Pressure on food inflation stemming from inclusive growth
11. Unlike the growth-inflation tradeoff, the possible tradeoff between inclusive growth
and inflation has not received much attention. The need for making growth inclusive is
incontestable, but it is important to recognize that policies aimed at inclusion can stoke
inflationary pressures, at any rate in the short-term. I could mention two examples here: first,
the significant increase in rural wages triggered by the MGNREGS, and second, inflationary
implications of the proposed Food Security Bill.
12. The MGNREGS, guaranteeing at least one hundred days of wage employment to
rural labour, in implementation since February 2006, has pushed up rural wages, in line with
the expected outcomes of the scheme. The indexation of the wage rate to CPI-AL since the
beginning of 2011 has exacerbated the wage-price inflation spiral. NSSO survey data
(61st Round and 66th Round) suggest that nominal wages of workers, in both rural and
urban areas, increased much faster in the second half of the 2000s than in the first half. In
most states, wageshave increased faster than CPI-RL inflation, pushing up real wages
(Chart-5).
13. Consistent with the characteristic of a low income country, increase in wages in
India has quickly translated to increase in per capita expenditure. Average nominal per capita
expenditure increased sharply in the second half of the decade (2005-10) compared to the
first half (2000-05), rising from 3.6 per cent per annum to 10.5 per cent in rural areas, and
5.3 per cent per annum to 10.9 per cent in urban areas. The MGNREGS has evidently set
the floor for the rural wage level, making wage push inflation more visible and prominent.
Admittedly, increase in wages need not be inflationary provided it reflects higher productivity,
but that is not currently the case, a point to which I will return later.
14. The National Food Security Bill, 2011 is another potential source of pressure on
inflation, and its inflationary impact will depend on the extent to which it will raise demand for
food grains relative to the normal increase in supply. The proposed bill targets two categories
of households - priority households and general households - under which 75 per cent of
the rural population (with at least 46 per cent of the population belonging to priority
households) and 50 per cent of the urban population (with at least 28 per cent of the
population belonging to priority households) will become entitled to subsidized food grains.
The price restrictions are quite exacting and failure by the government to meet the
obligations entails payment of a food security allowance to the beneficiary.
15. Estimates suggest that 68 per cent of the country's 1.2 billion population will get a
legal entitlement for food grains after the bill is enacted, significantly raising the annual grain
procurement demand even as the available marketed surplus would not increase
correspondingly. This will create demand pressures, which will inevitably spillover to market
prices of food grains. Furthermore, the higher food subsidy burden on the budget will raise
the fiscal deficit, exacerbating macro level inflationary pressures.
(iii) Large increases in MSPs of food grains
16. Recent years have witnessed a significant increase in minimum support prices
(MSP) of several agricultural commodities, pushing up food inflation. This is particularly
evident from the neatly anchored co-movement of market prices and MSPs for rice and
wheat (Chart-6). The Commission for Agricultural Costs and Prices (CACP) has typically
followed a cost plus pricing formula for determining the MSP, and in an environment of rising
wages and increasing input costs, rising MSPs have accentuated inflation pressures.
17. Compared with the past, hikes in MSPs for wheat and rice have been more
substantial in recent years, as the following table shows.
18. Given the cost plus formula for the determination of MSPs, the increase in MSPs as
above is consistent with the rising input costs as evidenced by figures below.
19. It is a fair presumption that MGNREGS has considerably affected labour costs while
also tightening availability of agricultural labour during peak seasons. Given that Indian
agriculture is labour intensive, sustained wage pressures can keep food price inflation high
even in years of record food production as was the case in 2010-11.
(iv) Shocks from global food inflation
20. Given India's growing integration with the world economy, global food prices affect
our domestic prices even if there is no trade. Global food price pressures have been quite
acute in recent years reflecting growing demand and a weak supply response. Demand side
pressures have stemmed from growing population and rising incomes. Supply side pressure
have been triggered by a host of factors - increasing urbanization, diversion of land for
biofuel production, inadequate investment in research and technology, spikes in costs of inputs
such as diesel and fertilizer and disturbances arising from climate change. The impact of
these factors underpinning high food prices was amplified further by country specific policy
interventions, particularly export bans on specific commodities by certain countries. Import
barriers in some countries to protect domestic producers and large subsidies to farm
production in several advanced economies have also influenced the supply response of farm
output to distorted price signals.
21. According to an assessment by OECD-FAO, global food inflation situation will
remain grim over the next ten years. It is important to note that prices of food items actually
declined in real terms over several decades from early 1960s to early 2000 (Chart-7). This
trend began to be reversed, gradually during 2003-06, and rapidly thereafter up until the
2008 global financial crisis. After some moderation in 2009, food prices have again edged
up, tending closer to pre-crisis peaks. The OECD-FAO Agricultural Outlook 2011-20
indicates that prices may be higher in real terms over the five years 2015-20, relative to the
levels prevailing during the five year period 1998-2003 by 40 per cent in case of rice, 27 per
cent for wheat, 48 per cent for maize and 36 per cent for oil seeds. What the above global
outlook clearly suggests is that we will not get any comfort from the global situation in
managing our food inflation.
22. Even in a situation of low global prices, India does not enjoy the import option given
the huge size of our consumption. Global food markets are notoriously thin, and even the
mere signal of a large consumer like India entering the market can spike up prices.
Moreover, in some commodities such as wheat and sugar, Indian prices have been higher
than global prices (Chart-8) suggesting that even if imports could improve domestic supply,
they would not soften inflationary pressures.
(v) Financialisation of commodities - a new source of price pressure
23. Some analysts contend that speculation in commodity futures has been a key driver
of global food inflation in recent years. In general, there has been a marked increase in
financial investment in commodity markets, relative to both global GDP and physical
commodity production. Do activities in commodity futures market reflect genuine needs of
hedging? Does speculation systematically influence the commodity prices and lead to
increased price volatility? These are questions that are as yet largely unsettled in academic
and policy discussions. At any rate, the financialisation channel is often perceived to have
magnified the impact on prices of the disequilibrium between demand and supply, thereby
weakening the role of fundamentals in the price formation process.
24. In India, prices of several commodities which are not traded on the commodities
exchange, such as fruit and milk, have significantly increased in the recent period. Moreover,
certain commodities that were banned for trading in 2007, such as rice, wheat, tur and urad
also exhibited price increases subsequently. Even after the ban imposed on trading of sugar
in 2009, sugar prices had increased considerably. Evidence of any relationship between
futures market activities in commodities and their spot prices is ambiguous. Nonetheless, this
needs close monitoring and certainly further research.
IV. Addressing the challenge of food inflation
25. Having discussed the sources of food price pressures, let me now turn to how we
may respond to the challenge of food inflation.
(i) Raise agricultural productivity
26. The Green Revolution, entailing adoption of high yielding variety (HYV) seeds in the
mid 1960s and the use of the fertilizer-pesticides-irrigation package, resulted in quantum
jumps in productivity (i.e. output per acre), especially of rice and wheat. By the early 1980s,
productivity across all major crops had peaked, but the momentum had slowed thereafter.
Consequently, per-capita availability of food grains, especially of rice and wheat, has started
declining (Chart-9). A comparison of crop yields across G-20 countries shows the extent to
which India has lagged behind others (Chart 10).
27. Even our best productivity achievements in terms of yields of major crops are way
behind world numbers. During 2010-11, Punjab, with the highest yield in rice, produced
3.8 tonnes per hectare as against the world average of 4.3 tonnes per hectare. Yield of
oilseeds in Tamil Nadu, the highest in India, at 2.1 tonnes per hectare is lower than the US
average of 2.7 tonnes per hectare. There are wide variations in productivity levels of crops
across states. Unlike food grains where the Green Revolution improved the food security
situation, we are still not self-sufficient in pulses and edible oilseeds. The demand for other
farm products like fruits and vegetables has also been rising significantly faster than supply,
putting pressure on food inflation.
28. The growth of agriculture and allied sector was most impressive during the 6th Five
Year Plan period (1980 to 1985) when it peaked at 5.8 per cent. The annual average
agricultural growth rate moderated thereafter as shown in the following table.
29. How do we respond to declining growth and moderating productivity improvements?
The overall policy framework for agriculture, driven primarily by remunerative prices and
subsidized provision of inputs, needs to change; the focus would have to shift to productivity
and selective policy stimulus to items where the supply response has been weak. Public
expenditure needs to reorient towards building capital infrastructure for agriculture which in
turn would "crowd-in" private investment and help realize the full potential of agriculture
growth. There has been no major technological breakthrough in agriculture since the Green
Revolution of the mid-60s. There have been achievements in some specific crops such as
cotton, basmati rice and maize, but that needs to be broad based. The Green Revolution
also needs to penetrate the eastern region, where the yields have generally remained low.
30. Management of climatic concerns is becoming increasingly important given the
continuing dependence on rainfed farming, frequent floodsin eastern India, frost, particularly
in north-western India, and heat waves and cyclones on the east coast. These climatic
changes are likely to significantly increase volatility in agricultural production. Recent large
increases in prices of some items like onion, sugar, vegetables and cotton are, at least in
part, a result of seasonal weather related factors, both domestic and external.
(ii) Rethink price policy interventions
31. Paradoxically, in India, we subsidize both agricultural inputs and outputs, and we
subsidize both producers and consumers. There is a case for revisiting the subsidy regime
for a number of reasons, including the pressure it exerts on food inflation. Subsidies on
inputs (fertilizer, electricity, irrigation) to incentivize production and subsidies on output for the
PDS system, entail a large fiscal burden (Chart-11). Over and above the input subsidies,
remunerative MSPs and procurement for the public distribution system (PDS) at prices linked
to MSP further distort the price situation. There is a moral hazard here like in any subsidy. A
farming sector that depends excessively on input subsidies and cost plus MSPs to raise
production does not have much of an incentive to raise productivity. If the amount spent on
subsidies could be diverted to augment capital formation in agriculture and creation of rural
infrastructure, higher productivity would raise the income of farmers while lowering the prices
for the consumers.
32. MSPs pose a major policy dilemma. Remunerative prices are necessary to engineer
the desired supply response, but higher MSPs also lead to higher inflation. A segment of the
population could be protected against inflation through the subsidized PDS, but depending
on the difference between the PDS price and the MSPs at which procurement is made, and
the quantity supplied through PDS, food subsidies could swell.
33. The share of agriculture in GDP has declined significantly (to about 15 %), but a
large section of the labour force (about 53 %) still depends on agriculture for its livelihood. If
the per-capita income of those who depend on agriculture has to increase, productivity of
agriculture has to increase (so that even without higher food prices, per capita income could
increase) and the percentage of labour force depending on agriculture has to decline (which
would require creation of employment opportunities in non-farm activities).
(iii) Improve supply chain management
34. The supply chain through which farm products move to reach the final consumers is
a major source of price pressures. Two initiatives, currently under debate, that could
potentially improve the situation are: (a) revamping the PDS to check leakage of food
subsidies, and (b) allowing entry of FDI into multi-brand retailing.
35. Let us take the PDS first. The Government's food management policy has been
largely driven by two goals: (a) maintaining buffer stocks to deal with food shortages and
thereby ensuring food security; and (b) providing food at subsidized prices to the poor
through the PDS. The food stocks at any point of time, thus, reflect the end result of additions
through procurement and depletions through release for PDS.
36. Management of food stocks is riven by a debate between two opposing points of
view. One view is that food stocks should play a market stabilization role such that whenever
market prices rise significantly, reflecting particularly supply chain manipulation, stocks
should be released into the market to soften prices. The opposing view is that use of food
stocks to intervene in the market dilutes the role of competitive market forces, and that the
Government should instead focus on easing supply chain rigidities.
37. Given the enormous administrative costs of the PDS and its perceived leakages,
several alternatives have been suggested, although none of them is without its specific
problems. By far the most straightforward is direct cash transfers, but its implementation is
conditional on universal financial inclusion. Besides, since cash is fungible, the objective of
distributing food at subsidized prices can potentially be compromised. Distribution of food
grains with utilization linked to UID is another option, but that again is conditional on
universal UID coverage. In the event of a switch over to cash transfers, the supply chain
could become even more important in rural areas, since by manipulating supply and prices,
food dealers could extract a share of the cash transferred to the beneficiaries.
38. There are also several proposals on the table for improving supply chain
management. Given that protein food inflation stems especially from perishable items such
as milk, eggs, meat, fish, vegetables and fruits, the case for a better supply chain
management becomes stronger. The most actively discussed option is allowing FDI into
multi-brand retail. The Government's discussion paper on the subject argues that super
market-chains could lower costs and increase efficiency because of scale economics. They
will also lead to better safety and quality standards.
39. Evidence from cross-country experience on the benefits of multi-brand FDI on
inflation is ambiguous. Several questions persist. Will the supermarket chains, focusing as
they do on urban consumption centres for scale of economy reasons, leave the rural
population behind? Also, if there are such clear scale economies and cost advantages, why
aren't domestic investors jumping in to exploit the potential?
40. Another issue in supply chain management is reform of some restrictive statutes
and regulations. Even as production of vegetables and fruits has increased in recent years,
around 40 per cent of it goes waste between the farm gate and the market for want of cold
chain and transport infrastructure. Implementation of the model Agriculture Produce
Marketing Committee (APMC) Act 2003, which provides for direct marketing, contract
farming and setting up of markets in private and cooperative sectors is a possible option to
address this problem.
(iv) Manage competition for land from non-farm activities
41. Land is the single most important input for agriculture. Besides being a key
determinant of socio-economic status, it provides collateral for credit and for security in the
event of natural hazard or contingencies. The supply of land, as we know, is fixed. Over the
years, there has been a significant change in the pattern of land use. Net sown area, which
increased at a rate of 18 per cent during 1951-71, has either declined or remained stagnant
since then. Increased cropping intensity over the years, however, has led to an increase in
gross cropped area, though at a slowing pace in recent decades. As a result, there has been
no significant increase in the share of net cropped area in total geographical area since the
1970s.
42. A notable aspect of the changing land use pattern is that the share of cultivable land
not used for agricultural purposes has increased from a low of 2.8 per cent of the total
geographical areas in 1950-51 to 7.5 per cent in 2004-05. This may be indicative of
increased diversion of agricultural land for non-agricultural purposes, such as urbanization,
housing, industrialization, and infrastructure. It is a fair presumption that such diversion would
have further gained pace since 2004-05. Land acquisition for industrial and other
commercial uses is an issue that has been headline news in recent years; clearly, it is an
emotive issue involving difficult tradeoffs. No matter how the tradeoffs are resolved, the
reality of increasing demand for land from fast growing and more productive sectors cannot
be ignored. The possibility of declining arable land available for cultivation underscores the
importance of increasing productivity if we are to contain food inflationary pressures.
43. There are several other problems. First, land holding in India is highly fragmented,
with marginal holdings (of one hectare or less) accounting for as high as 62 per cent of all
operational holdings. The small farm size in a labour surplus agrarian sector leads to
intensive use of land, but in the absence of supporting infrastructure and capacity to access
modern technology and inputs, productivity remains low. Second, rainfed agriculture
constitutes as much as 55 per cent of the cropped area and 45 per cent of the total
agricultural output. More than 70 per cent of pulses and oilseeds production as well as a
substantial part of horticulture and animal husbandry produce is from rainfed farming,
underscoring significant continuing monsoon dependence. Third, water is going to be as
precious as land in the long-run, and costs of irrigation will increase significantly, not only in
terms of the actual cost of access to the irrigation facility, but also by way of costs arising
from competing demand from non-agriculture sectors for the limited supply of water. Fourth,
dry land farming would have to receive greater attention, but there will be greater competition
even for dry lands from urbanization and infrastructure.
V. Monetary policy and inflation
44. Now let me turn to a question that is more directly relevant to the Reserve Bank -
what is the role of a central bank in combating food inflation? As I said earlier, the answer to
this question spans the entire spectrum.
45. That monetary policy should respond if there is inflation, meaning there is sustained
increase in the general price level, is beyond question. But high food prices often result from
adverse supply shocks or large increases in input costs. The conventional wisdom is that if
inflation expectations are well anchored, monetary policy need not react to supply shocks.
This premise is based on the assumption that the supply shocks are purely temporary. This
assumption does not always hold. In the real world, oftentimes supply shocks are structural
and lead to a permanent trend upward shift in prices.
46. So, the challenge for a central bank is to determine if the supply shock is temporary
or permanent. If it is permanent, then the change in relative prices caused by it can result in
higher general inflation, in the first round by the higher input costs, and in the second round
through the impact on inflation expectation and wage bargaining. In other words, when
supply shocks impact the trend or the core component of inflation, monetary policy should
respond.
47. The question of responding to a supply shock gets more complex in the context of
the growth inflation trade-off. Unlike demand shocks, supply shocks have asymmetric
implications for inflation and growth. In the case of a negative demand shock, such as wealth
loss caused by say, a crash in asset prices, the impact on output and prices is generally in
the same direction. The policy response in such a situation is unambiguous. In the event of a
negative supply shock, such as lower farm output resulting from monsoon failure, however,
while headline inflation goes up, output may come down. Thus, in the case of a negative
supply shock, monetary policy confronts the dilemma of stabilising output versus containing
inflation.
48. Oftentimes, this is a delicate balancing act. If the supply shock is transitory, then the
preferred policy response could be to accommodate the price pressures, recognizing the
limitations of monetary policy in directly dealing with supply induced price pressures. If on the
other hand, the supply shock persists, or due to strong demand conditions, the supply shock
transmits to other components of general inflation, then monetary policy has to respond.
Thus, in case of the former, monetary accommodation prevents further disruption to the
growth momentum. In the latter case, however, ant-inflationary monetary response may
involve some sacrifice of growth.
Conclusion
49. Let me now conclude. The thrust of my address has been to emphasize the several
factors that are driving food inflation: (i) shift in dietary habits towards protein foods;
(ii) pressure stemming from inclusive growth policies; (iii) large increases in the minimum
support prices (MSP) of food grains; (iv) shocks from global food inflation; and
(v) financialization of commodities.
50. Inflation is a regressive tax and hurts the poor the most. The impact can be
particularly severe in a country like India with a population of 1.2 billion, a per capita income
of less than $1500 and a large share of food in the total consumption basket.
51. As discussed earlier, the direct role of monetary policy in combating food price
pressures is limited, but in the face of sustained high food inflation, monetary action may still
be warranted to anchor inflation expectations. A lasting solution to food price pressures lies
in a supply response that raises agricultural production and productivity, improves supply
chain management and sets the right incentive framework for both producers and
consumers. The outlook on food inflation in the short to medium term will be determined by
the speed and quality of such a supply response by the Government.