It's India's Year of Inflation

In mid-July the Gujarat Cooperative Milk Marketing Federation, an Indian dairy products maker, raised milk prices in New Delhi by as much as 4.2 cents a liter, to almost 64 cents. The increase has a real impact on the city's poor, who scrape by on as little as $2 a day. And the government of Prime Minister Manmohan Singh is indirectly responsible: Singh is trying to lower India's budget deficit—it's at a 16-year high—and has started to roll back $5.5 billion in subsidies for gasoline and diesel. With gas prices suddenly higher, it's a lot more expensive to run a fleet of milk trucks. "We were left with no choice but to hike prices as transportation costs have jumped," says R.S. Sodhi, the milk co-op's chairman.

This should have been a good summer for Singh. The economy will probably grow more than 8.5 percent in 2010, much better than last year's 6.5 percent. The Prime Minister no longer needs the two big communist parties in his coalition to pass legislation, so he can push market-friendly reforms such as the elimination of fuel subsidies, which eat up 2.5 percent of the budget .

Yet the specter of inflation is haunting Singh's government. The benchmark wholesale price index jumped 10.5 percent in June from the year before, after a 10.1 percent gain in May. Consumer prices paid by industrial and farm workers in India are increasing at almost 14 percent annually, the highest among 17 countries tracked by Bloomberg in the Asia-Pacific region. In the long run the fuel price increase will encourage companies to use energy more efficiently. For this year, though, the price hike will add about a percentage point to wholesale inflation, according to the Reserve Bank of India, the central bank.

Two other factors are driving inflation. Food prices jumped after 2009's disastrous monsoon resulted in poor harvests of rice, lentils, and sugar. The revival of the industrial economy has created bottlenecks in the supply chain even as the middle class buys more cars, apparel, and other goods. "I've never seen such a time when we had to struggle so hard to make ends meet," says Shweta Kapoor, a housewife haggling over vegetables with a vendor in Faridabad township near New Delhi. "You name it, everything has become expensive."

Singh is under attack for not containing the situation. "Why didn't you release more grains in the market to reduce the impact of the drought?" ex- central bank governor Bimal Jalan asks rhetorically in a Bloomberg interview. The government keeps stores of grain and meat for emergencies: "They could have done a good job making it available," says D.K. Aggarwal, chairman of New Delhi-based fund manager SMC. The opposition Bharatiya Janata Party organized a nationwide strike on July 5 when Singh reduced the fuel subsidies.

Reserve Bank of India Governor Duvvuri Subbarao has reversed last year's loose money policy and raised rates three times since March, to 5.5 percent. "They still have more work to do," says Brian Jackson, an emerging markets strategist at Royal Bank of Canada in Hong Kong. Subbarao wants to curb prices without strangling the recovery—a tough trick to pull off. "We heard inflation will come down by March, then April," says Jalan, who ran the central bank between 1997 and 2003. "It was supposed to come down by now."

Singh's government is calling on Subbarao to get tough. Montek Singh Ahluwalia, deputy chairman of the powerful Planning Commission, said recently the central bank should make "whatever adjustments it feels necessary," as inflation above 10 percent is "not acceptable." Another rate hike is expected when the central bank meets on July 27.

Singh and Subbarao are both counting on lower food prices by September, when the harvest starts to come in. The 2010 monsoon season is off to a better start. If food prices don't abate, inflation could settle in and require major tightening by the central bank to bring it under control. That would endanger growth—and weaken Singh's government. When milk prices go up, voters take note.

The bottom line: Inflation is becoming a major political and economic issue in India. Food prices are largely to blame, and the central bank is under pressure to act.

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