Investors here, there and everywhere have been busy counting their stock market losses these days. Naturally, they have been too distracted to notice another growing threat to their finances—inflation.
The rate at which prices are climbing is worrisome. Higher inflation means your money buys you less stuff than before. The official inflation rate has already broken through the Reserve Bank of India’s (RBI) comfort barrier of 5%. And economists have been busy reworking their inflation forecasts these days.
It’s now clear that the central bank had made the right call in its January policy statement, when it decided not to cut interest rates because of the growing inflationary threat. Mint has generally supported RBI’s nuanced management of capital flows and its decision to consider inflation as a major threat at this juncture.
Any central bank has to fire away at the inflation problem, because rapidly rising prices and high inflation expectations generally distort economic decisions and harm long-term growth. Disinflation is good for sustained growth, as we have seen across the world since the mid-1980s.
There will always be debate about how much of the drop in trend inflation and the jump in global growth over these past two decades was because of central banks, and how much because of technology, productivity and the entry of two billion low-wage Indians and Chinese into the world economy. However, there is little reason to doubt that central banks did have a role of play in getting down inflation all the way down to almost zero. But that’s history. Inflation is on the upswing again. It has touched a 14-year high in Europe, for example.
A central bank that increases interest rates to fight inflation inflicts inevitable collateral damage to economic growth in the near term. What could the extent of the damage be? And to what extent is a society ready to give up growth today to protect growth tomorrow?
Many economists have calculated the output losses a country will have to suffer in its battle with inflation. This is the sacrifice ratio. It broadly measures the loss of output that an economy has to deal with for every percentage point drop in the inflation rate because of central bank policies. But most of these studies have been focused on the record in the developed countries.
RBI had calculated India’s sacrifice ratio in the 2002 edition of its annual Report on Currency and Finance. It estimated that India will have to sacrifice 2 percentage points of economic growth for every 1 point drop in the inflation rate. This study was briefly commented upon and then forgotten. It was done at a time when inflation was low and many economists believed that the world was heading for a bout of deflation, or falling prices. High inflation was the last thing on their minds.
What seemed an academic exercise then could become an important policy guide now. RBI will have to take a call on whether it should wait and watch, or move fast to douse inflation right away. And it will need political support for this. In an election year, politicians will have to ask themselves what would be a bigger vote loser— higher inflation or lower growth? The current signs are that they believe higher prices in the bazaars are the bigger worry.
In a paper he wrote in 1993, Princeton economist Laurence Ball studied 65 episodes of disinflation in developed countries and examined how much output was lost each time a central bank fought to bring down inflation. He noted that the sacrifice ratio was lower when the speed of disinflation was higher. Benign neglect is a dangerous course of action. Or, as he evocatively described it, “Cold turkey is less costly than gradualism.”
There have been several other studies that chart out how the sacrifice ratio changes, depending on how open an economy is, how independent its central bank is and how flexible its labour markets are. “The size of the sacrifice ratio has been regarded as a guidepost in determining the speed of disinflation to be engineered by monetary policy action. The potential costs include lost output, higher unemployment, and related social ills… The sacrifice ratio becomes relevant not merely in assessing policy effectiveness in a one-time transition from high inflation to low inflation, but also in the context of the ongoing policy rule,” said Muneesh Kapur and Michael Patra of RBI in a 2003 paper.
Inflation is right now just a few basis points above what RBI says it is comfortable with. The research on the sacrifice ratio suggests that India may have to give up around a couple of percentage points of growth if inflation is to be brought down by a percentage point. That’s more than one standard deviation of the growth over 18 quarters since 2003-04.
It may be time to rework those uber optimistic growth forecasts as well.
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