Inflation can be defined as a sustained change (increase) in the general level of prices of goods and services in the economy. As prices rises, i.e. inflation, goods one purchases today become costlier tomorrow. What this simply means is that the amount of goods one can buy today for one rupee would not be the same tomorrow. One would get a lesser amount of goods for the same rupee spent. While there is a lot of contention amongst economists over the real reason of inflation, there are two broad theories to the same.
The first is 'demand led inflation,' which suggests that the real cause of inflation is the supply of money being greater than the output in the economy, i.e., too much money chasing too few goods. The second theory is 'cost-push inflation.' It states that when costs of firms go up they need to increase the prices of the goods they manufacture in order to maintain their profit margins, thus leading to inflation. Increased costs can include rising wages, taxes or increased costs of imported materials. Also a sudden shock on supply side might cause inflation.
Is Inflation bad?
Inflation is not bad for the economy till it remains under control. However, inflation is disastrous if it is unanticipated and very high. And history has an example to prove the same. In the year 1922, Germany faced inflation of the level of 5,000% (yes, it is five thousand percent!) which played havoc on the economy, rendered millions jobless and worst of all, it helped Hitler to rise to power. Inflation is necessary to keep the growth of output (value) positive. Now if we consider the output (in value terms it is called topline) of companies we find that a part if it is due to volumes and a part is due to rise in prices. Consider the steel industry recently. The topline of most of the companies increased by 35%, but if we take a closer look real increase in terms of volumes is was just 7%-8%, the rest (27%) was due to rise in prices. Also, since inflation is preceded by demand growth it is indicative of a growing economy. This in turn affects business sentiment and hence the growth momentum of the economy is maintained, leading to higher wages and employment.
On corporate front inflation can play a critical role. In high inflation, corporate profits swell because of the topline growth. But is the growth real? It depends on the method used for inventory valuation. Most of the companies use FIFO (First in First Out) method of inventory accounting/valuation. Thus, the raw material they account for is cheap, since they have bought when it was cheap so the cost is less vis-a-vis the price (which rises because of the price hike). This boosts the bottomline growth of the company, because costs are lesser and prices are higher. So, any spectacular jump in profits in a highly inflationary environment must be looked upon with some caution.
The Indian context...
In the Indian context, inflation is measured based on the Wholesale Price Index (WPI), which is different from what is done in other developed countries (where they use the Consumer Price index, or CPI). In India, the inflation (based on WPI), for the last 10 years, has been at an average of around 6%. This is, however, lower than that for the past three decades when the inflation averaged 8.5%. As a matter of fact, in the year 1974, inflation levels in the country touched a high of 26%!
The basic reason why inflation in India was higher is said to be the huge fiscal deficits run by the government and subsequent monetization (printing money) of the same. This led to increased liquidity, i.e. money supply in the market, thus resulting into the high levels of inflation in the economy. However, off late, the IMF restricted monetization of deficits by governments and the latter were left to opt for a different route to satisfy their ever-increasing demand of money. However, this borrowing by government to meet its expenditure requirements was not matched by an equivalent increase in output in the economy. Also, the increased demand for money led to rising interest rates making it very expensive for corporates to borrow from the market. These high costs of borrowings then led to these companies pass on the pressure to customers, thus resulting into increased price levels, or inflation.
India Off Late...
Barring FY01, inflation in India have been under control in last few years. The reason behind this seems to be the lack of demand for credit from the industry. Large capacities were created in the country in anticipation of high growth in early 90's, which didn't materialize. There was oversupply of the goods in the economy. Internationally, oil prices were ruling low and commodities were in down turn. Also, food production was normal in almost all the years, keeping prices under control.
In India, inflation has been over the 6% mark for the past few months. The main reason for this being the rise in commodity and petroleum prices. Iron and steel prices have risen by over 28% YoY (as on January 28, 2004). Prices of manufactured products are higher by 5.8%, while those of power, fuel and light and lubricants is higher by 8.4% over the same period. Also, the prices of food articles have risen in past few weeks. Rise in food article prices may be good for the economy considering the fact that 60% of the population is still dependent on agriculture for their survival. Rise in food prices will increase in their income and it will create demand for the other products in the economy. But then, at the same time, they may have to pay higher for other goods.
The rising inflation might stop Reserve Bank of India (RBI) from further reducing interest rates because this will further take the real return into negative territory. It has started affecting the bond yields. The bond yields are at 5.4%, from the low of 5.0%. One of the main reasons cited for this rise in yields is the persistence of inflation over 6% for last three weeks. Since there is no sign of commodity and fuel prices falling, it is quiet possible that inflation remain in the 6% range in the short-term. Moreover, fuel and commodities are primary goods, so the trickle down effect of high prices might be seen in other products also. Good monsoons will increase the rural income, which will create the demand for the goods. Thus, the prices of primary articles are also unlikely to come down.
In the long term however, the picture may change due to higher agricultural output and a likely downturn in the commodity cycle, which may bring down prices. The level of international oil prices will also continue to have a strong bearing on inflation in the Indian context. To that extent, RBI's target of maintaining inflation in the 4%-4.5% region may prove to be a challenge.