At over 11 per cent, the latest inflation figure is a shocker and portends tough times ahead for the economy and the financial markets. The government deserves much of the blame. By Vivek Sharma

Finally we reached there today. After many weeks of anxious anticipation, wholesale inflation has touched double digits. We now lead the BRIC group as the top inflation generator, though China may give us a tough fight for the top position if it gets its inflation arithmetic right. Though India is way behind current world inflation leader Zimbabwe, where some economists say annualised inflation is probably over one million per cent or even more, the sharp increase has come as a rude shock.

At over 11 per cent, inflation is at a 13-year high. The last time inflation was this high, or only nearly so, was when Dr Manmohan Singh was the finance minister and C Rangarajan was the RBI governor. 13 years back, in response to rising prices, the RBI hiked interest rates. While that served the intended purpose, the RBI's actions also stopped the investment boom in its track and GDP growth slowed down. Corporate India was saddled with high-interest loans and many companies had to wait many years and go through painful restructuring before they were confident of survival.

Now Dr Singh is the prime minister and Rangarajan is his chief economic advisor. He also has the mercurial P Chidambaram as finance minister and the genial Y V Reddy as RBI governor in the economic team. Still, the opposition and the Left parties don't seem to have much faith in the inflation fighting credentials of this high-profile economic management team. They have demanded Chidambaram's head and one pygmy party,  a part of the left front, has even called for the resignation of the prime minister himself.

How did we get here?
Those who live in flood-prone areas might know this. Every year, sometimes before the rains but usually when flooding begins, district administrations take precautionary steps like fortifying river banks with sand bags to prevent breaches. During the early days and weeks of rains, these temporary bulwarks provide a false sense of security. When the rains intensify, the sand bag walls give away when no one is really prepared for it.

Fighting inflation with subsidies and price controls is no different. When prices begin their upward march, the government can afford the subsidy costs. When prices rise further, the government will browbeat producers into accepting 'voluntary' price controls and if they are not willing to comply, will impose price controls. The government will soon run out of options as the subsidy costs become unbearable and eventually will be forced to let prices rise. But, by then, the economy is used to the make-believe world of low inflation and is least prepared to handle the sudden rise in prices. It is easier to manage gradual changes, even when they are adverse, but it is the sudden spurts that do the most damage.

Yes, the main reason behind the most recent jump in inflation is record oil prices. The government can argue that it had no way of predicting oil prices. No one could have forecast a year or even six months back that crude oil would hit $140 a barrel. Now that prices have exceeded even the wildest estimates, it is easy to blame the government for not acting earlier and increasing fuel prices in a steady and gradual manner.

But, that is precisely what political leadership and policy management is all about. Leaders and managers who later inspire legends know the precise moment when they need to be decisive. The recent fuel price hike took a very long time in coming and international crude oil prices almost doubled in the meantime. All that while, the government kept procrastinating abiut aking the tough political decision of raising domestic fuel prices in a pre-election year, hoping that oil prices would fall back. When oil prices continued to rise, against the government's wishes, there was no alternate plan either.

If the 10-per cent fuel price hike announced recently was spread over this period, political opposition would have been more subdued. Inflation would have still hit double digits, maybe even earlier, but there would not have been a sudden spurt, which play into the hands of the opposition parties. The RBI would have started monetary tightening earlier and, probably, GDP growth rates would have been marginally lower. But producers and consumers would have seen that coming and would have been better prepared for it and the economy would have recovered faster than it will now.

There is no point in blaming 'external factors' now and feigning helplessness. The damage has already been done by trying to avoid fuel-price hikes in a pre-election year and for that the ruling alliance may now end up paying a very heavy political price.

How reliable is inflation data?
Instances of governments manipulating price data to show lower inflation are rampant, in all parts of the world. Most recently, the Argentine government introduced a completely new consumer price index which is widely believed to have been manipulated. In protest, some employees of the government statistical agency resigned and put together another price index, which showed inflation at nearly double the official levels. Russia is also contemplating a new index, though inflation there has declined to 7.7 per cent in May from 11.9 per cent in 2007.

In India, the doubts are not about whether inflation is underreported. Critics say the way inflation is measured in the country is outdated and hence the reported inflation is way above the real numbers. Unlike most large economies, in India the central bank and the government tracks wholesale price inflation for policy making. Even for wholesale price inflation, year-on-year price changes are measured when most countries have switched to month-on-month measurements.

Year-on-year measurements compare current price levels to those that prevailed in the previous year and can be said to be more sensitive to the base effect. Hence, most economists are in favour of month-on-month price measurements which are then annualised for yearly figures. It is also essential that seasonal effects on prices are removed, a practice widely followed in most developed economies. Our statistical agencies do not measure core inflation – after removing food and energy prices which are considered more volatile – either. Despite recent scepticism, core inflation measures do give a better idea about the source of price increases and help ease political and public pressure on central banks.

How significant are these factors in the Indian context? The IMF recently constructed its own wholesale price index for India, measuring and comparing the price changes month-on-month.

The results were startling to say the least. The IMF price index gave an inflation figure of less than 5 per cent when the official WPI inflation was well above 8 per cent. This is not to say that the IMF figure is more accurate as that index was also constructed using the same government data, much of which is not updated in time. But, it is shameful that doubts are being raised over the reliability of official data as critical as inflation. And there is no way of telling how accurate the data is until the system is put through an overhaul, which is long overdue.

How do we get out of this mess?
The plight of an economy shocked by the release of 'bottled-up' inflation is no different from that of a patient who ignores early symptoms and is eventually diagnosed with a life-threatening disease. If she had sought medical treatment when the symptoms first appeared, it would have been easier, cheaper and much less painful. Now that the disease has been diagnosed rather late in the day, the treatment will be expensive, medicines will be stronger and the patient will take a much longer time to recover.

The RBI now has no alternative but to keep hiking rates until the inflation genie is back in the bottle. Remember, the RBI's so called 'comfort range' for inflation peaks at 5 per cent. Even in the last policy statement, the central bank talks about a medium term inflation target of 3 per cent, which is not a realistic target anymore. To bring inflation down to even 5 per cent will need strong monetary policy measures. Whoever follows Y V Reddy as RBI governor will have a tough time indeed. A bad monsoon or sustained rise in oil prices will make it tougher.

The economy will pay the price when the RBI tightens further. Consumer demand growth, especially for durables, will slip further or may even turn negative as interest rates go up. Profit margins will slump and expansion plans will be put on hold as the IPO market slips into a deep sleep and credit gets prohibitively costlier. The stock market, as my colleague and fellow domain-b columnist, Shivshankar Verma said in his column earlier this week (See: For investors, it's time to be patient), will go through a prolonged period of consolidation with a negative bias.

The government could ease the pain through fiscal sops, like benevolent parents who pitch in with some spare cash when their kids fall on difficult times. But, recent fiscal profligacy – farm debt waiver, rural jobs scheme and the impending pay hikes for government employees – has severely restricted the government's room for financial manoeuvres.

Chidambaram was heavily banking on sustained growth in government revenues when he made his optimistic projections about fiscal deficits and the government's ability to finance all the grand populist programmes. With the economy slowing down, tax revenue growth will obviously fall short of expectations. The government cannot afford to cut back spending as general elections are due early next year. If anything, it will be forced to increase spending. That is bad news when the real fiscal deficit is way above government estimates and may have negative repercussions on the country's credit ratings in future. 

Critics say the last two years of Manmohan Singh's earlier stint as finance minister, when he gave in to political pressure and went slow on reforms, take some sheen out of his legacy. Now, ineffective inflation management and the growth slowdown at the fag end of his stint as prime minister will partly dull the impressive achievements this government can justifiably be proud of.

The 'Dream Team' of Manmohan, Chidambaram and Montek should have done better.