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What’s the rate beyond which inflation hurts growth?

What’s the rate beyond which inflation hurts growth?
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First Published: Fri, Oct 14 2011. 09 55 PM IST

Illustration by Jayachandran / Mint
Illustration by Jayachandran / Mint
Updated: Fri, Oct 14 2011. 09 55 PM IST
Illustration by Jayachandran / Mint
The chief domestic concern for the economy is currently the high level of interest rates and inflation. Elevated interest rates have slowed down the economy and are impeding investment. Will the Reserve Bank of India (RBI) continue to raise its policy rates? How much growth is it willing to sacrifice to tame inflation? These questions are considered in two recent working papers from the RBI. Both these papers show that, above a certain level, inflation starts to hurt growth and there’s no trade-off between inflation and growth—the only objective, at these high levels, would then be to reduce inflation, without bothering about growth. That’s exactly what the RBI has done.
The paper by Sitikantha Pattanaik and G.V. Nadhanael of the Department of Economic and Policy Research at the RBI gives a number of reasons why high inflation hurts growth. The authors say that inflation has an adverse impact on private investment, because price signals become distorted, leading to misallocation of resources. Higher inflation could make domestic firms less competitive relative to imports and could hurt exports. Input costs, including wages could go up and would hurt profits, thus restraining entrepreneurs from investing. Inflation could lead to lower demand, affecting growth.
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The researchers explain that the Philips curve, which shows the relationship between the inflation and unemployment rates, will start to bend backwards above a certain point, which means that higher inflation would lead to more unemployment. The authors quote deputy governor Subir Gokarn, “Below the threshold, workers and producers do not raise their wage and price demands very often because the impact of inflation is not too visible. By contrast, they respond very quickly above the threshold because they are worried that high inflation will rapidly erode their living standards or profitability. In short, when inflation is high, the behaviour of workers and producers increases the likelihood that it will increase further.” The authors cite three trends in India that show inflation is well above the threshold: first, inflationary expectations, seen from RBI surveys, are above the headline inflation rates; second, the pace of increase in wages has also been much more than inflation and third, corporate finance data suggest that growth in staff costs in recent quarters have been higher than the rate of growth in earnings.
So what is the threshold level of inflation in India? The researchers use three methods to arrive at this cut-off point, which they put at a wholesale price inflation rate of 6%. A rate of WPI (Wholesale Price Index) inflation above 6%, therefore, hurts growth in India.
The second paper also empirically estimates the threshold level of inflation for India. Its conclusion: “For WPI-inflation up to 5.5%, there is positive impact on growth, which is statistically significant. The relationship reverses when WPI-inflation is beyond 5.5% and inflation effect on growth turns negative.”
The Reserve Bank has indicated that it expects the WPI inflation rate to be 7% by the end of March 2012. But that is much higher than the threshold rates worked out by both these papers. Does it mean then, contrary to market expectations, the central bank will continue to have a tight monetary policy beyond March 2012?
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First Published: Fri, Oct 14 2011. 09 55 PM IST