Home >Opinion >Views >Opinion | The chimera of a costless way to keep a lid on inflation

In the recent debate on India’s growth slowdown, one aspect that seems to have completely bypassed commentators and policymakers is the role played by prolonged disinflation after the central bank adopted inflation-targeting in 2016.

One of the most important economic reforms accomplished by the Narendra Modi government was the Agreement on Monetary Policy Framework, which formalized the targeting of inflation. In 2014, the Reserve Bank of India (RBI) had set up a committee under the chairmanship of Urjit Patel to revise and strengthen the monetary policy framework, and the committee recommended the adoption of this framework. The idea has been popular, and is considered very effective in delivering low and stable inflation. Since 1990, it has been adopted by eight advanced and 32 emerging economies.

According to the agreement between the Indian government and RBI, the objective of monetary policy is primarily to maintain price stability, while keeping in mind the objective of growth. It mandates RBI to contain consumer price inflation within 4% with a band of (+/-) 2%, and the central bank would be seen as having failed to meet its goal if it goes above 6%, or slips under 2%, for three consecutive quarters. If this happens, RBI will have to explain the reasons for its failure and give a time frame within which the target would be achieved.

The implementation of the idea has led to a considerable fall in retail inflation over the years; from its peak of 11.16% in November 2013 to 1.46% in June 2017. It was at 1.97% as recently as in January 2019, and at 4.62% in October 2019, though it rose to 5.56% last month. In fact, even prior to the formal announcement of inflation-targeting, a disinflationary process had started, and, within the span of one year, from November 2013 to December 2014, 6.23 percentage points were knocked off the inflation rate. Thus, it has been observed that RBI’s monetary policy has been successful in achieving its stated objective of disinflation, removing a significant economic imposition on the poor. However, an issue that received minimal attention in the Urjit Patel committee report and in the recent debate on the growth slowdown is that of the output cost of such large and quick disinflation.

In a paper published in the Journal Of Development Economics titled Inflation Targeting In Emerging Economies: Panel Evidence in 2010, authors Ricardo D. Brito and Brianne Bystedt studied the impact of inflation-targeting using a data set of 32 emerging market economies. The study found that inflation-targeting regimes have had a significant adverse impact on their average real output growth. The authors conclude that even if one accepts that the regimes have been effective in dampening inflation, this has had significant costs by lowering output growth.

That disinflation entails a cost in terms of growth forgone is well established in macroeconomic literature. In a classic 1994 paper estimating the output cost of disinflation, titled What determines the sacrifice ratio?, Laurence Ball notes that disinflation has been a major cause of recessions in modern economies—perhaps the dominant one. For example, in the US, recessions in the 1970s and 1980s coincided with falling inflation caused by tight monetary policy. Macroeconomic theory suggests that in the absence of a favourable supply shock, lower inflation requires a period of reduced output. Therefore, before deciding the quantum, speed and period of disinflation, policymakers must estimate the output that might be lost during this transition to a lower inflation regime.

The sacrifice ratio—the percentage of a year’s real gross domestic product that must be forgone to reduce inflation by one percentage point—is dependent on several factors, such as how quickly people revise their expectations of future inflation. If the revision is not quick, the sacrifice ratio can be relatively large. Similarly, countries with inflexible wage-setting institutions may also have larger sacrifice ratios.

In the Indian scenario, Ravindra Dholakia and Kadiyala Virinchi, in their paper titled How Costly Is The Deliberate Disinflation In India: Estimating The Sacrifice Ratio, published in the Journal Of Quantitative Economics in 2017, estimate short-run and long-run sacrifice ratios, and argue that these—as the real cost of disinflation to society—are relevant not only in the short, but also in the long run. Ashima Goyal and Gagan Goel, writing in a recent Indira Gandhi Institute of Development Research working paper titled Correlated Shocks, Hysteresis And The Sacrifice Ratio: Evidence From India, note that some of the growth loss estimated by them for the period starting the third quarter of 2011 to the first quarter of 2017, which includes the period of the inflation-targeting regime, was due to prolonged tight financial conditions as inflation-targeting was adopted while the country was on a fiscal deficit reduction path. They also note that inflation-targeting may have heightened forward-looking behaviour, thus increasing the growth-loss from a tight-money policy even if it did not have an appreciable impact on inflation itself, as there was a sharp reduction in oil prices in 2014.

All this indicates that while analysing the reasons for India’s recent growth slowdown, it’s very important to investigate the implications of the recent disinflationary phase. India is better off with low and stable inflation, but this has surely not been costless.

Amlendu Dubey & Akanksha Mishra are, respectively, associate professor and research scholar of economics at IIT Delhi. These are the authors’ personal views

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