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Opinion | Don't blame inflation targeting for the farm crisis

A misdiagnosis can lead to inefficient solutions and end up increasing the cost for the economy in the long run.

February 04, 2019 / 09:33 PM IST
Q20. Sir Chhotu Ram was the originator of the concept of compensating the farmer for at least the expenses incurred by him on farming. The concept has now evolved into 'Minimum Support Price'. What was his most famous creation?

Q20. Sir Chhotu Ram was the originator of the concept of compensating the farmer for at least the expenses incurred by him on farming. The concept has now evolved into 'Minimum Support Price'. What was his most famous creation?

Rajesh Kumar

Depressed prices in the farm sector are said to be the biggest factor for the loss of ruling Bharatiya Janata Party in the recent state assembly elections. Food inflation in December, for instance, came at negative 2.51 percent. Thus, the Union government is reported to be working on a farm package, which is likely to be announced in the interim budget to be presented later this week.

However, at the broader level, in order to avoid a similar outcome in the future, it is important to understand the actual reasons behind the fall in agricultural prices. Lower income in rural areas, among other things, can affect aggregate demand.

Interestingly, some commentators believe that the adoption of the flexible inflation targeting framework led to disinflation/deflation in food prices. This explanation rests on an extremely weak foundation. In fact, at the time of the adoption of inflation targeting, critics argued that it will not work in India, as the framework will have little or no impact on food prices—the largest component in the consumer price index. Now that prices are falling, commentators are counting it as one of the reasons.

India formally adopted flexible inflation targeting in 2016. Consequently, the Reserve Bank of India now has a legislated target to maintain consumer price inflation at 4 percent with 2 percent tolerance band on either side.

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The general experience shows that inflationary expectations get well anchored, once the central bank establishes credibility by containing inflation for a reasonable period. To be fair, early signs suggest that the Indian central bank is moving in that direction. However, it is hard to establish at this stage that the adoption of inflation targeting has pushed farm prices to unexpectedly lower levels. In fact, it is important to note that core inflation continues to remain elevated and is a concern for the central bank. So, it is highly unlikely that inflation targeting has had the maximum impact on prices in the sector (agriculture) which was expected to remain unaffected in the first place.

Further, although it is correct that the present government raised minimum support price (MSP) at a muted pace until recently, it is hard to argue that this was done solely to help the RBI achieve its target. Besides, a small number of farmers benefit from the MSP mechanism. This is perhaps the reason why MSP at cost plus 50 percent did not push prices as was widely expected.

The weakness in food prices has surprised both analysts and policymakers. For instance, in the December meeting of the monetary policy committee, RBI deputy governor Viral Acharya noted: “It is not easy to ascertain fully at this stage the nature of the collapse of food inflation seen in recent months…A clearer assessment is particularly clouded by divergence in the direction of price movements in data in key food items provided by the Department of Consumer Affairs (DCA) and realized food inflation for October. Such divergence in the direction is rarely observed.”

One possible explanation for falling food prices could be lower global prices. Although trade in food products is significantly protected, global prices do have an impact. For example, in a 2007 study, Shweta Saini and Ashok Gulati concluded: "Irrespective of trade bans/restrictions, the Indian domestic prices converged with their global counterparts in the medium to long run and the only purpose served by these bans and restrictions was to smooth this convergence process." Food prices in the international market have remained muted in recent years. The food price index of The Food and Agriculture Organization of the United Nations was at 168.4 in 2018, compared with the level of over 200 in 2014.

Additionally, it is possible that the farm sector is undergoing a change at the fundamental level, possibly with the better use of technology, which has helped improve production.  However, the policy architecture is not adequately prepared to handle the surplus. The agriculture sector needs reforms to ensure that farmers get a fair price for their produce without stroking higher inflation.

Clearly, tolerance for higher inflation or pushing MSP to unsustainably higher levels are unlikely to solve the problem in the agriculture sector. Lower inflation on a durable basis is essential for maintaining macroeconomic stability and attaining higher economic growth in the long run.

A misdiagnosis can lead to an inefficient solution and end up increasing the cost for the economy in the long run.
Rajesh Kumar
first published: Jan 28, 2019 12:33 pm

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