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The future of wheat inflation

posted Sep 30, 2011, 11:37 PM by Puneet Goyal   [ updated Oct 5, 2011, 11:33 PM ]
Posted: Saturday, Oct 01, 2011 at 0210 hrs IST

: Inflation, especially in food prices, has been persistently high in India during the past twenty four months. This has been a source of concern to policy-makers. Fortunately, food price increases are now starting to ease, after the major spike that occurred in the wake of the severe drought of 2009. However, there still remains concern that we: (a) need to better understand the factors that drive such spikes in key prices; and (b) design more effective policies to prevent such future price spikes.

The main approach to understanding inflation and its drivers has typically rested, on the whole, in assessing aggregate macroeconomic (aggregate supply and demand) conditions, which then typically leads to consideration of macroeconomic (and monetary) policies as the principal tool to deal with inflation surges. That may indeed be appropriate in most circumstances, but is often a blunt, sometimes costly instrument that can stifle growth, especially if price pressures arise from (temporary) supply constraints. Therefore, it may be important to complement an aggregate macroeconomic analysis of inflation with microeconomic analysis: to ascertain if inflation is being driven by specific price spikes in important food and non-food commodities, which has the potential to drive other commodity prices in a cost-push manner.

What happens to wheat prices has major implications for food and overall inflation trends in India. Based on weights, a 10% change in wheat prices would be expected to lead to a nearly 1% change in overall food inflation in the WPI, ignoring any cross-price effects on other foods; and a 2% change including such cross-price effects. For the combined rural-urban CPI, a 10% change in wheat prices would produce by itself about 1.5 percentage points change in overall CPI inflation, but potentially as much as 3 percentage points change in overall CPI inflation, taking into account cross-price effects of wheat price increases on other foods.

(1) We first need to check whether the “law of one price internationally” applies to wheat in India; that is, whether Indian wheat prices follow, or not, global wheat market prices; there can be many reasons, such as quality, distance, transport costs, and most importantly, policy “wedges” (export bans, import restrictions) preventing private trade in wheat that can drive wheat markets in India to be more autarkic; on the other hand, inability to rigidly apply trade restrictions may significantly weaken the impact; and domestic prices cannot possibly stay well divergent from global conditions for long because of physical arbitrage conditions and financial arbitrage in commodity futures markets. This is an eminently testable first proposition. We expected that international price movements would have some role, and this was indeed the case, although weaker than expected. Moreover, the coefficient or size of this impact is well below 1, closer to 0.2, suggesting that wholesale domestic wheat markets and price formation in India are only moderately affected by international price movements (so far) and instead significantly intermediated by other domestic factors.

(2) If domestic market conditions and factors are therefore important, then we need to account for the impact of changes in demand and supply in domestic wheat markets. But we cannot directly or reasonably accurately observe short-term supply and demand conditions, which ultimately drive commodity prices. Instead, a “reduced form” model is derived, where we need only to know changes in stocks of the commodity—since changes in supply and demand will show up immediately in change in stocks. Private stocks are mostly unobserved or not measured well for most commodities in India; internationally, private agents and reliable public information seek to measure changes in stocks as the main predictor of near-term price movements (in such standard commodities as oil, or other commodities, for example). Fortunately, in wheat markets in India, the Government is a major player, procuring to maintain farm prices at remunerative levels (set a floor) and disposing of such stocks through various public distribution schemes (PDS), where we do have reasonably accurate public data on public stocks of wheat—which we can then use to predict near-term wholesale prices, if they have any effect. This is, again, a testable proposition. A higher level of physical wheat stocks in the PDS—measured in relation to buffer stock norms—expectedly lowers market wholesale prices. However, the effect is statistically quite weak and often insignificant. The policy implication is clear: domestically procured public stocks have a far lower market effect than is to be expected, primarily because, we presume, public stocks are rarely used effectively to stabilise wholesale market prices of wheat in India.

(3) Unexpected deviations in weather typically are used in the private forecasting community to signal likely future changes in wholesale markets. Drought during growing seasons will be expected to reduce supply and drive prices higher, and vice-versa. We test this effect, using a directly measured weather variable, a drought index that measures the deviation from normal rainfall in the weather stations in India. While the presence of drought expected raises wholesale wheat prices, the effect is not very significant statistically.

(4) Commodity futures trading ban on wheat has operated on and off for some time in India, and this allows us to test, instead, for the presence or absence of any effect on domestic wheat prices from financial arbitrage with global wheat prices, and generally, the presence of financial futures markets. The effect of commodity futures trading has been highly contested: while many increasingly believe that shift of speculative flows of financial capital to commodity futures markets is one very important reason for rising global and domestic commodity price spikes episodically during the past decade, the evidence for this has been hotly contested and scanty. Indeed, a past official commission in India was unable to find any strong evidence one way or another. In this study, we find a statistically significant and very strong effect of commodity futures trading that raises domestic wholesale prices, independent of the effects of other factors described above, or controlling for them. This effect is found for both its effect on domestic wholesale prices of wheat, and on the relative domestic wholesale price to international prices.

The paper turns to assessing specific policies and options to counter possible excessive domestic price volatility, using econometric estimates of factors affecting wheat price offtake from the PDS described earlier. Five possibilities are recommended:

(1) Open-market stabilisation efforts, using large and growing PDS stocks and their sales (or purchases)—counter to market price movements—should play a much more powerful role than it does. Indeed, the evidence suggests that PDS wheat off-take has been very non-market driven so far, and one of the immediate policy tasks should be to expand the open-market sales instrument (in both directions, to procure more when prices are low, and sell more when prices are high). This is now extensively used with good results elsewhere in the world, including Bangladesh.

(2) A second policy instrument is, if needed, to regulate commodity futures in wheat more effectively (and avoid an outright ban except during excessive international prices and volatility) to drive a wedge between international and domestic prices when and if it appears that there are excessive financial inflows into wheat commodity futures markets unrelated to underlying factors;

(3) Export bans, in contrast, probably remains a weak and likely ineffective or blunt instrument, at least on evidence available in this paper. However, market participants consistently believe that export bans lower domestic wheat prices, and therefore, more careful sifting of evidence is needed.

(4) The fourth instrument is that of expanded targeted welfare schemes of PDS distribution to the poor, which is one important way of protecting the poor from volatility in market prices; but doing so more effectively on the questions surrounding the efficacy of targeted distribution—for example, strengthening food stamps or other alternatives to check leakages and pilferage from PDS.

(5) We may also need much more attention to the quality of publicly procured and stored PDS wheat stocks, because of some suggestive evidence that PDS is taking on characteristics of being an inferior “Giffen” good.

These changes, together, should be able to play a more powerful role in moderating domestic wheat price volatility and the transmission of global wheat price shocks. In order to be able to do so, however, changes in the functioning of public agencies (such as FCI and state agencies) may be also needed—because their mandates are circumscribed to play a more effective price-stabilisation function. A review of such agency-specific instruments and effectiveness may be called for.

Excerpted from Domestic Wheat Price Formation and Food Inflation in India: International Prices, Domestic Drivers (Stocks, Weather, Public Policy), and the Efficacy of Public Policy Interventions in Wheat Markets