It doesn't take much to sniff out this one. Prices of everyday items such as fruits and vegetables and wheat have turned dearer; fuel, of course, only seems to get more and more expensive and, assuredly, the worst isn't over yet; and now, your monthly housing loan repayments have gone up too, thanks to a hike in lending rates by most banks. The inflation numbers say it all: The Wholesale Price Index (WPI), more watched because it has a larger number of items in the inflation basket and is updated every week, is inching up. In the 12 months to August 12, the WPI rose 4.92 per cent, higher than forecast and higher than the previous week's annual rate of 4.82 per cent. (The following week, it fell, but a negligible 0.01 percentage point). In the corresponding period the previous year, the figure was 3.7 per cent.

To middle-class India, living on a fixed monthly salary, that's bad news. But like an unattended common cold that can turn into a life threatening infection, high inflation can not just derail household budgets, but the overall economy. The good news: Far from leaving it unaddressed, the government has taken steps to check inflation-from reducing taxes on commodities of mass consumption to keeping a check on the interest rates (lest industry and retail consumers decide to cool off; see Friendly Interventions). For instance, the government recently cut import duty on wheat, and has asked banks to ensure liquidity in the market to ensure that interest rates don't rise further. "Hardening of global interest rates is not in our control, (but) what we are doing is to ensure ample liquidity so that the impact of hardening interest rates is softened," Finance Minister P. Chidambaram told reporters recently.

The million-dollar question, however, is this: Are these measures appropriate and enough or does more need to be done to ensure that high inflation doesn't choke economic growth? After all, inflation is a symptom, a response to supply issues, demand constraints or supply chain mismanagement. The political overtones of supply issues have never been underestimated. For example, the BJP-led state government in Delhi was voted out of power when onion prices shot through the roof in 1998 and became an election issue. Rising input costs for industry can slow down growth in the economy, since companies will find it hard to absorb costs, and passing the buck to the consumer will end up making goods and services more expensive and, hence, affect demand.

On the demand side, when there is cheap capital available in the market, profligacy kicks in with different segments of consumers. Retail consumers shop till they drop, collectively ramping up prices that kick up inflationary forces. Industry, meanwhile, embarks on an expansion spree, hoping the bullish sentiment will not lose steam and the incremental produce will find buyers when it hits the market. Evidently, what matters really is not inflation but the sentiment that it brings along. After all, inflation affects different classes of society in different ways.

BT takes a look at some of these issues, and brings out the nuances of the simmering inflationary forces.

Cost Push

The last time India imported wheat was eight years ago. This year, imports are expected to be as high as 5 million tonnes, a little less than a 10th of our production. With global wheat prices ruling at double that of two years ago, it is not surprising that the WPI of wheat has risen 10 per cent in the last year. As a consequence, farmers growing wheat are the only ones insulated from this inflationary measure. The trend is not limited to wheat. The same holds true for pulses and palm oil, where prices have risen sharply. Not surprisingly, the Consumer Price Index (CPI)-it reflects retail prices, but not very accurately-for the agricultural workers has nearly doubled over the year. Since urban rather than rural spending has been driving growth, India's overall growth is unlikely to suffer significantly on this count, argue economists. "The effects of inflation on the rural sector will take some time to surface," points out Rajesh Shukla, Chief Economist, NCAER, an economic think-tank.

High inflation: Can derail household budgets and the overall economy

However, fact remains that the issue is accentuated by the government's inefficient public procurement system, compounded by constant alterations in the import policies for commodities. "There are supply chain issues that squarely land in the court of the agriculture sector. That, to my mind, is the immediate problem that the government needs to tackle," says Govind Rao, Director, National Institute of Public Finance and Policy (NIPFP), and a member of the Prime Minister's Economic Advisory Council. "There has been a shortfall in domestic supplies due to demand as well as hardening of international prices. We have taken steps to augment domestic supplies," contends Union Agriculture Minister, Sharad Pawar.

As much as fuel for the human body has become dearer, so has that for machines. Given that we import over 70 per cent of our crude oil requirements, the impact on the economy is significant. However, much of the impact is absorbed by the government and the public sector oil companies, since retail price of close to 60 per cent of the products (petrol, diesel, LPG and kerosene) are controlled. So, how fat is the bill? It is estimated that a $10 (Rs 470) per barrel rise in crude oil-the increase till date over the previous year's level-will result in an additional payout of Rs 35,000 crore for the economy. Of this, the industry will shoulder around Rs 15,000 crore. "Domestic industry has been able to absorb this cost through efficiency gains, increase in scales owing to growth, and intelligent substitutions wherever possible," says Ajit Ranade, Chief Economist at Mumbai-based Adiya Birla Group.

"The real worry for industry is the possibility of demand sagging" R. Seshasayee President/CII	"Our advice to banks was meant to ensure industries got competitive credit" Ashok Lahiri Chief Economic Advisor/Fin. Min.

Furthermore, the robust growth in exports (at an average 20 per cent over the last four years), on the back of sustained global demand, offers a firm cushion against the dampening effects of inflation. The sharp decline of the rupee vis-à-vis the dollar in the recent past (during April-July, the rupee declined by almost 5 per cent) has only improved the export prospects, which grew by as much as 30 per cent last year. Says Jitender Balakrishnan, Deputy Managing Director, IDBI Bank: "Inflation is currently below 6 per cent and I don't think it will go up substantially. Of course, oil prices have been increasing and media reports have suggested that oil may even touch $100 (Rs 4,700) per barrel."

While public sector oil companies have significantly shouldered the burden of high oil prices, fears of an imminent retail price hike have kept the pressure on domestic interest rates. Interestingly, on this front, the government and the RBI have been pulling in opposite directions. The RBI has raised the reverse repo rate (the rate at which it sells its securities to banks, thus sucking out money from the system), signalling a higher interest rate regime. Since a lot of money is chasing a handful of assets, a higher interest rate will deter a rise in the flow and keep inflation at bay. The Finance Ministry, in contrast, has tried to hold on to lower interest rates through its role as the owner of public sector banks, fearing that the prevailing consumption-led growth, especially in the retail consumer segment, will suffer if interest rates were raised.

Dearer Credit

A clear indication of the growing strain on the banking system is the fact that the credit to deposit ratio for banks has reached new highs (that is, there is greater credit offtake) while the investment to deposit ratio, which is reflective of the investment in government securities (that goes towards funding the fiscal deficit) has been dropping. Says Ashok Lahiri, Chief Economic Advisor, Finance Ministry: "The recent surge in the inflation rate has been on account of the rise in prices of primary products (wheat, sugar and pulses). Clearly, this is a supply-chain issue. As regards the Finance Ministry's move to advise public sector banks (in the back drop of RBI raising the reverse repo rate), it was aimed at ensuring that credit to productive industries is not affected." While this argument wears thin when it comes to the issue of preserving the autonomy of commercial banks, there is also a fundamental debate on whether the intervention, if at all required, was premature. Monetary theorists argue that the first time that supply-led inflation occurs, the government should not intervene. It is only the second time around that intervention should be made.

"At the end of the day, demand management is key to handling inflation" S. Chaudhuri Chief Economist/ ICRA	"We have taken steps to hike domestic supplies of wheat and pulses" Sharad Pawar Union Agriculture Minister

Meanwhile, is the case of a supply-led inflation overstated? "At the end of the day, demand management is key to handling inflation," says Saumitra Chaudhuri, Chief Economist, ICRA, and a member of the Prime Minister's Economic Advisory Council. "There is obviously a demand issue that is intrinsic to the rising inflation rate, especially, when we look at the increasing money supply in the system. Further, we need to remember that as we integrate with the Asian economies, inflation needs to be well below the projected 5 per cent mark," he notes.

Evidently, industry is not exactly complaining right now. Says President of industry association, CII, and Managing Director of Ashok Leyland, R. Seshasayee: "Industry margins are indeed under pressure due to inflation and this cannot be made good by efficiency measures. However, the prevailing pace of economic growth has ensured that the overall profitability has not been affected." The real worry for industry, he adds, is the possibility of demand sagging due to the negative sentiment on inflation. "So far, this has not happened, but the fears are entirely justified," he cautions.

While the prices of industrial input commodities have risen sharply in the recent past, the fear of inflation is more due to the rise in agriculture commodity prices. Sure, government interventions have provided some relief, but there is far more that can be done, given the shoddy state procurement and pricing system. Signs of activity are visible as the private sector is slowly nudging its way into organised farm retail, where huge efficiencies are waiting to be reaped. Until organised retail-like in the US, where Wal-Mart is credited with single-handedly keeping costs down-significantly increases its share of 3 per cent, supply chain inefficiencies will continue to add to the cost. And the RBI and the government will have to continue walking the fine line between credit-led growth and inflation.