A focus on price stability is received wisdom for most central bankers today. Pioneered by the Reserve Bank of New Zealand in 1990, inflation targeting has since been adopted by about 25 central banks from developed and emerging market countries. Today, even those central banks that do not explicitly pursue inflation targeting usually come with the same persuasion. The empirical rationale for this focus is that monetary policy has generally not been capable of consistently delivering higher growth or employment (witness the US today), but has more reliably delivered upon targeted inflation.
On the other side of the coin, does higher long-term inflation reduce growth and investment? For Indian policymakers this is not an arcane question to be debated in some far-away international economic conference. It is a question whose answer could have material impact on the lives and livelihoods of millions of Indians.
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In a seminal paper entitled “Determinants of Economic Growth: A Cross-Country Empirical Study”, Robert J. Barro (NBER working paper 5698, 1996) concluded that “for a given starting level of real per capita GDP, the growth rate is enhanced by higher initial schooling and life expectancy, lower fertility, lower government consumption, better maintenance of the rule of law, lower inflation, and improvements in the terms of trade”. In another cross sectional study, Khan and Senhadji (IMF staff papers vol. 48, No. 1, 2001) empirically concluded that there exists a threshold level beyond which inflation exerts a negative effect on growth. The authors suggest that while the results of the paper are important, some caution is warranted. The estimated relationship between inflation and growth does not provide the exact channel by which inflation affects growth, beyond the fact that, because investment and employment are controlled for, the effect is primarily through productivity. This also implies that the total negative effect may be understated.
Most economic studies agree that high inflation would have an adverse impact on growth. The evidence at lower inflation rates is rather weak. If threshold inflation does indeed have a negative impact on growth, then the question is “how low does inflation need to be”? The answer is contextually dependent on the nature and structure of the economy, and could well vary from country to country. Little research appears to have been done on this for India, and it is empirically unclear if a policy focus on (say) 6% structural inflation rate is materially worse from the point of view of future growth than 4%. Or conversely, if it is actually better.
In a recent speech to the Central Bank Governance Group in Basel, the governor of the Reserve Bank of India (RBI) stated that “inflation targeting is neither feasible nor advisable in India, and for several reasons. First, in an emerging economy like ours, it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. The Reserve Bank cannot escape from the difficult challenge of weighing the growth inflation trade-off in determining its monetary policy stance”.
While he described the growth inflation trade-off as a challenge, he did not elaborate on the determinants of that trade-off for India. RBI has widely communicated an inflation comfort zone of “5-5.5%”. Presumably this range comes from a study reported in the RBI Report on Currency and Finance (2002), Growth, Inflation and the Conduct of Monetary Policy that concluded that the “growth maximizing rate of inflation in India was 5%”. The period of study for that data ended more than a decade ago. That number could well be different since India has made substantial supply-side gains since then.
India enjoyed rapid annual growth averaging a little over 8% in the period from 2003-08 at an average inflation rate slightly below 5%. Since the crisis, growth has returned to an average rate of over 8%, but inflation has been persistently higher at nearly 8.5-9% per year. The worry is that this inflation gets encrusted as inflation expectations and gradually spirals out of control. This spiral then affects incentives for investment which, in turn, becomes detrimental to long-term growth, goes the argument. RBI has raised rates 10 times since March 2010 to normalize policy and curb inflation. Given the slower growth now, both in India and abroad, it seems likely that we will soon see a new lower range on inflation.
For RBI to engineer a soft landing it will need to update its understanding of the growth inflation trade-off. Given the long lags in monetary transmission, using an outdated study as its guide could mean a world of difference to those most vulnerable to a hard landing.
Too much policy—monetary and fiscal—is being conducted with information that is dated and an erroneous belief that nothing much has changed in India.
PS: “Inflation is, always and everywhere, a monetary phenomenon.” Milton Friedman. Except in India (my addition).
Narayan Ramachandran is an investor and entrepreneur based in Bangalore. He writes on the interaction between society, government and markets. Comments are welcome at firstname.lastname@example.org