»The Daily Reckoning by Bill Borner

Will the 7th Pay Commission recommendations lead to higher inflation?
26 NOVEMBER 2015

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The advantage of writing regularly is that one can dwell into great detail on issues of national economic importance. Hence, this is the fourth column on the recommendations of the Seventh Pay Commission this week.

When I started writing regularly in the media nearly 12 years back, the communication with the readers was largely one way. One wrote a piece and then forgot about it. There was no feedback coming in from the readers. There was no way of figuring out whether something one had written had actually been read. If it had been read then what had the readers thought about it? Some feedback came from the colleagues, if they did read, what one had written (normally they didn't). The bosses did give feedback once in a while, especially if they didn't like something one had written.

But now with the advent of the social media, feedback (both good and bad) keeps coming in all the time, and questions keep getting asked. Also, if readers like something they share it. This gives some idea of what the readers are actually interested in. There is constant communication with the readers these days and that's a good thing.


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One of the questions that I recently got asked on Twitter was: "Will the 7th Pay Commission recommendations lead to higher inflation?" As I have mentioned multiple times this week, the Pay Commission recommendations will lead to an increased spending of Rs 1,02,100 crore by the government, to pay higher salaries of central government employees and higher pensions of retired central government employees.

How will this lead to inflation? A part of this increase in salary and pensions will be spent to buy goods and services. As this money chases the same amount of goods and services, prices will go up. This logic seems very straightforward-as straightforward as saying, a cut in interest rates leads to people and companies borrowing more, which is something one hears all the time.

In fact, that is how things played out in the aftermath of the Fifth as well as Sixth Pay Commissions, once their recommendations had been accepted. The higher salaries and pensions led to a higher consumption which led to higher inflation.

As Crisil Research points out in a recent research note 7th Pay Commission: A non-inflationary boost to consumption and investment: "During the Fifth Central Pay Commission(CPC) payout, overall inflation rose by 657 basis points[one basis point is one hundredth of a percentage] on-year in fiscal 1999, while non-food inflation in the same year rose only 141 boints. During the Sixth CPC payout years, however, overall inflation rate rose by 611 basis points on-year between fiscals 2009 and 2010. But this time the increase in non-food inflation was higher and lagged - up 492 bps during fiscals 2010 and 2011."

So will this phenomenon play out this time around as well? A major reason for inflation the last two times was the fact that the Pay Commission increases came much after they were due. The Sixth Pay Commission increase was due from January 2006. But the report was submitted only in March 2008 and accepted by the government in August 2008. Hence, arrears had to be paid and they were paid only in 2008-2009 and 2009-2010.

This meant that people suddenly ended up with a lot of money in their hands, as payments were made. As Crisil Research points out with regard to the Sixth Pay Commission: "Large arrear payments coincided with the rapid rise in rural wages adding to core inflationary pressures then. These two factors are expected to be absent, this time."

This time the salary increases are due from January 2016. Unlike the last time, the Pay Commission recommendations have come in before the due date. Also, chances are that the government will implement these recommendations starting from April 2016, the next financial year. Given this, only a limited amount of arrears will have to paid, meaning that people will not suddenly end up with a lot of money in their hands, as they had last time around.

Another factor that needs to be kept in mind is that most factories are not running full steam at this point of time. As Reserve Bank of India governor, Raghuram Rajan, recently pointed out, most factories are running 30% below capacity as of now.

This means that factories can easily ramp up supply if the demand goes up due to higher consumer spending, without leading to higher prices. Typically, if factories are running full steam, a rise in demand cannot be matched immediately with a rise in supply and that leads to prices going up. But that sort of scenario is unlikely to playout as of now.

Over and above this, as and when the recommendations of the Seventh Pay Commission are accepted by the central government, pressure will mount on state governments to increase the salaries and pensions they pay as well. The state government increases won't happen overnight and will take some time to happen. And this will allow the inflation due to increased demand, if any, to spread out over a period of time.

As Crisil Research points out: "State governments - which have more employees than the Central government - tend to implement these with a lag. Therefore, while there is a push to consumption demand, it takes place over time allowing supply-side factors to adjust wherever possible."

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