Is ‘unusually’ low food inflation a cause of worry?

Food inflation, as measured by the Consumer Price Index (CPI), has been negative for the last three months (implying prices are declining) and has averaged less than 2 percent in the past two years.

Agricultural inflation, as measured by the Wholesale Price Index (WPI) series, has been negative in five out of the last six months and has averaged less than 1 percent in the last two years. GDP deflator, a measure of the level of prices of all new, domestically produced, final goods and services in an economy in a year, for the agriculture and allied activities is estimated to be negative for the year 2018-19 as per Central Statistics Office’s (CSO) first advance estimate. This increased by just one percent in 2017-18. This compares to the long-term average of mid-high single digit inflation in each of the series. What the writer is simply trying to say is prices in the agriculture sector have barely increased in the last couple of years.

This is bad news for farmers and hence the narrative of ‘rural distress’ gained traction. Add to it, the fact that we are in an election year, creates for a very potent combination for national policymaking. The moot question to ask, though. is whether what we are seeing in terms of agriculture price cycle is unusual or structural in nature?

This is because the policy response will differ if low agriculture prices is a ‘new normal’. Reserve Bank of India (RBI), too, is expected to slash interest rates as the current low headline inflation is driven largely by abnormally low food inflation which could be here to stay. This assumption, however, is problematic for there is nothing to suggest that the current phase of low-price inflation is unusual. In fact, data suggests that agriculture crop prices have an inbuilt self-correcting mechanism, as one would expect in any other sector.

History suggests that there is nothing unusual about the current phase of low agriculture price growth (The writer used a 5-year agriculture GDP deflator to smoothen the year-to-year variation and isolate the medium-term trend). The history of agriculture prices in the last six decades suggest that agricultural price cycles have been remarkably consistent. In an upswing, price growth typically peaks at around 10 to 12 percent for a few years and in the down-cycle, price growth slows down to just two to three percent on average for a few years. There have been four such cycles since the 1960s and we are amid the fifth cycle. So, based purely on data, there is nothing unusual about what we are seeing in terms of agricultural prices. At least there is nothing yet to suggest the current phase of low-price growth is different from the past.

Agri price inflation in this cycle has been like past cycles. Source: RBI

Agriculture price cycles are highly correlated to real growth in agriculture in the last 30 years. Periods of high price growth and high volume growth are broadly in sync and vice-versa. Thus, what seems to be happening is that a period of high price growth suggests a demand-supply mismatch, and this spurs more output (so real agriculture GDP accelerates). This increased supply eventually results in price growth coming off or prices even declining as the demand-supply imbalance reduces. This reduces the profitability of Agriculture, reducing the output growth and setting the stage for a demand-supply imbalance to arise again. So, prices start to increase again, eventually.

Agri price inflation cycles coincide with periods of strong output growth. Source: RBI

The bottom line is, growth in agriculture sector is depressed but there is nothing ‘unusual’ about it. Indeed, if history is any guide, we are coming to the end of the cycle of low prices and price growth should start to pick up in the next few quarters. Further, this cyclical behaviour is what one would expect in any commodity sector.

The question arises, what should the government do about it? From a political perspective, given an election year, it is quite easy to understand the need for relief or a ‘package’. However, from a fundamental perspective the answer is complicated for a couple of reasons:

First, from a short-term perspective, any big fiscal expansion (even if it is funded by a transfer of reserves from the RBI or through higher asset sales), will be problematic. This is because the economy is currently doing reasonably fine with growth likely to be above 7 percent for the second consecutive year. Capacity utilisation is rising, profit cycle is reasonably buoyant and thus capacity expenditure is picking up.

With Oil prices having corrected sharply and already low food inflation, headline inflation is likely to remain benign allowing the RBI to cut interest rates. Thus, the economy is going to benefit from some monetary stimulus. This, in the backdrop of already elevated core inflation, even after the fall in oil prices, is above 5.5 percent. This suggests that underlying inflationary pressures in the economy are elevated and in sync with an economy that is growing at a healthy pace. In this backdrop, a big fiscal expansion will be like giving steroids to an economy. This is especially since the data suggests that we might be coming to the end of the downturn in agriculture price cycle in any case. It will boost demand in the short-run but almost certainly stoke inflation a few quarters out warranting a sharp U-turn from the RBI. This will shorten the current economic upturn. What the country needs is strong growth that can sustain for several years rather than very high growth that lasts for just a couple of years.

Second, even from a more fundamental perspective, agriculture does not need more steroids. A policy intervention aimed at reducing some of the distortions in the sector is most certainly in order. What is needed is a policy intervention that reduces the risk in farming and at the same time allows for market forces to decide on cropping patterns, landholding and input selection. A policy scheme that subsumes all the different benefits that the farmers are supposed to get with a simple Direct Benefit Transfer (DBT), for example, will most certainly improve the outcome for both the agriculture sector and farmers. This allows for market forces to operate and determine prices of both inputs and output and at the same time gives a certain guaranteed income to the farmer reducing the volatility of his incomes.

The question is, can the government, in an election year, undertake such a fundamental reform or will it succumb to the need to ‘be seen to have done something’ and thus repackage old tried but failed measures? The budget is just a few days away.