Is 6% The Right Inflation Rate For India After All?

For years, India has debated what the right level of inflation for the economy is. Is it the 5% informal objective pursued by the RBI for many years? Is it 2-6%, the range set for India’s flexible inflation? Or is it 4%, the mid-point of that range?A new research paper suggests that 6% may be the ideal level of inflation for India, adding that any attempt to bring it below that point comes at a significant cost to growth.“For macroeconomic policy targets consistent with maintaining fiscal deficit at 6% and current account deficit at 2% of GDP, our estimates suggest a threshold inflation level of 6.1% and optimal growth rate of 7.5% for India,” said a research paper authored by Ravindra Dholakia, Jai Chander, Ipsita Padhi and Bhanu Pratap.The paper was published as part of the RBI’s Development Research Group.The threshold is defined as the point beyond which inflation becomes detrimental to growth. For the purpose of the study, the researchers assessed the level of inflation that maximises the long-term growth in the economy subject to a prescribed level of fiscal deficit and current account deficit.The researchers studied data across 58 countries over the period 1995 to 2018. They came away with the finding that for emerging economies, higher threshold inflation goes alongside higher growth up to a point.For India, while growth is maximised around 6% of the long-term inflation rate, it is minimised around 9.5% of inflation, said the paper.The study, led by a former member of India’s monetary policy committee, points to the fact that the trade-off between long-run inflation and ‘steady-state growth’ is asymmetric.When the inflation target is less than the threshold level, the sacrifice is 40 basis points loss in growth per 100 basis points reduction in inflation from the threshold level. However, if the inflation target exceeds the threshold level, the sacrifice of growth is only 15 basis points for 100 basis points reduction in inflation towards the threshold level, it said..If we consider the inflation target at 4% instead of the threshold level of 6%, the long-term growth rate would decline by about 80 basis points. On the other hand, if we consider the inflation target of 8% instead of the threshold level of 6%,the long-term growth rate would decline by only about 30 basis points.Study - Threshold Level Of Inflation.The Indian government reaffirmed the inflation target at 4 (+/-2)% this year. The target was first set in 2016.Policy makers may choose to set the inflation target below the threshold level, but only by consciously sacrificing long-term real growth of GDP and hence the adverse impact on the rate of poverty alleviation, the authors wrote. “On the other hand, lower inflation has favourable redistribution effects particularly on the poor and is beneficial for financial stability. These costs and benefits of fixing a long-term inflation target will thus have to be considered while making the choice.”.The Four Macroeconomic CornerstonesThe study also made the case for internally consistent macroeconomic targets across key variables such fiscal deficit, current account deficit, inflation target and growth.The threshold inflation and corresponding growth depend on fiscal deficit as a percentage of the GDP and the current account deficit as a percentage of the GDP, the paper explained.If a country chooses the target values of FD/GDP and CAD/GDP to be achieved in the long run, its potential output growth gets determined through the corresponding value of threshold inflation.Citing the example of the government’s objective of making India a $5 trillion economy by 2024-25, the paper said this would have required a real growth rate of 8% over the six years since 2019, when the target was set. At the same time, a current account deficit of less than 3% is seen as desirable. Alongside these objectives, India also has a fiscal deficit target and an inflation target.All of these targets and objectives are set independently of each other, the study said. Such a situation poses a serious challenge for efficient macroeconomic management and monitoring in a country, it added.“Unless internally consistent targets for real growth, inflation rate, fiscal deficit and current account deficit on balance of payments as a proportion of GDP are set, the macroeconomic policies to achieve these targets individually would always result in shortfalls, sub-optimal outcomes and wastage of efforts and resources,” the paper said.

Is 6% The Right Inflation Rate For India After All?

Bringing inflation down below 6% towards 4% may lead to an 80 basis points decline in long term growth rates, says a study.

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Is 6% The Right Inflation Rate For India After All?

Bringing inflation down below 6% towards 4% may lead to an 80 basis points decline in long term growth rates, says a study.

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