Analysis. Why manufacturing investments are sputtering

The current target set for consumer price index (CPI) appears too low. If this is to be achieved, manufacturing prices have to be pushed to near-deflationary levels. As a result, investment activity could get restricted. It therefore, helps to increase the CPI target, as CPI and prices of manufactured goods are related.

To understand this, it is important to get the notion of relative prices. Consider a simple, two-product barter economy — with only grain and toys; either people are eating or playing. In this scenario, toys and grain will be exchanged based on supply and demand. Say, in the first year, 10 kg of grain is exchanged for 10 toys. Next year, though, the output of toys increases 10 per cent while that of grain grows only 2 per cent. So, grain will become more expensive relative to toys. You might need 11 toys to buy 10 kg of grain.

In other words, grain might become 10 per cent more expensive than toys. So, relative price shifts will occur even in an economy without money. Relative prices are “real prices”, reflecting demand and supply in the real economy.

Now let us introduce money and, by implication, a monetary policy. To continue with the above example, as monetary policy will not affect relative prices in the real economy, grain will get 10 per cent more expensive than toys.

If monetary policy aims that prices should rise by an average 10 per cent, prices of grain will rise 12 per cent and that of toys 2 per cent (the gap being 10 percentage points). Similarly, if monetary policy intends that the average price rise be 4 per cent, then prices of grain need to increase by 9 per cent and that of toys decline by 1 per cent (the gap still remains 10 percentage points). This effectively means that when an average inflation target is set, toy prices will drop.

How do we relate this to the Indian economy? Instead of toys, think “manufactured goods” and instead of grain “agricultural products,” the key point being that output of manufactured products can increase much faster than agricultural output.

This helps explain the divergence between the CPI and Wholesale Price Index (WPI or core WPI). Agricultural products/food items have a greater weightage in the CPI. The increase in relative prices of food items explains the high CPI.

Recent data shows that the gap between the call money rate and the price deflator (effectively, the inflation rate for the manufacturing sector) — the “real rate” of interest — has not been so wide for such a long time, at any point in the last decade-and-a half. It’s no surprise that private sector investment continues to be sluggish. The CPI in its current form has been calculated merely for a short while. So, there is no sufficient long-term data to calculate the “right” CPI level. If it is to be used as the target variable for monetary policy, the “right” level will have to be discovered over a really long period.

So, if near deflationary conditions persist in manufacturing, the CPI target may have to be raised to, say, 7 per cent. Going back to targeting WPI and core WPI remains a valid option.

The writer is Head of Research, ICICI Prudential AMC

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