India’s threshold inflation levels around 6%

Yesterday, RBI released  a series of papers on inflation.

• Measures of Core Inflation in India – An Empirical Evaluation
• Inflation Threshold in India: An Empirical Investigation
• Why Persistent High Inflation Impedes Growth? An Empirical Assessment of Threshold Level of Inflation for India

I just read the second one Inflation Threshold in India: An Empirical Investigation by Deepak Mohanty, A B Chakraborty, Abhiman Das and Joice John.

The paper is quite good and explains the basics of threshold inflation and what is its level in India. They calculate the this threshold based on 3 approaches and comes around 4.0% – 5.5%. For inflation upto 5.5%, impact on growth is positive. Anything over it, it starts to impact growth.

They clarify that inflation threshold and inflation target are different concepts. We should have targets lower than thresholds given the lag effect of mon pol:

It must be emphasised here that the concepts of inflation target and inflation threshold are distinct. Inflation targeting is a construct of monetary policy making in which a central bank announces a ‘target’ and then steers its policy tools towards achieving that target. Inflation threshold is a point of inflexion for the growth-inflation trade-off. Therefore, inflation threshold need not necessarily be the ‘target’ of monetary policy. In fact, the inflation objective or the target level of inflation for monetary policy should be lower than the inflation threshold, considering the existence of significant lags in the transmission of monetary policy measures and the costs of inflation.

So RBI should target inflation around 4.5-5% as threshold is around 5.5%.

What is this idea behind threshold inflation?

• Earlier Philips curve was seen as negatively slope showing tradeoff between unemployment and inflation. If you wanted lower inflation you needed to tolerate higher unemployment and so on.
• This was trashed when Friedman pointed that there is no trade-off but higher inflation now led to build in inflation expectations and more inflation in future. Over a short term there could be a trade-off but over long term inflation always leads to more inflation. So Philips curve could be negatively sloped in short run but is +ly sloped in the long run.
• Apart from Friedman ideas, it was found this Philips curve is actually backward sloping (See Box II.4) . It is negatively sloped at low levels of inflation, becomes positively sloped at high levels of inflation and turns vertical if inflation expectations converge to actual inflation. So, the point where the curve becomes +ly sloped you have threshold inflation levels. This varies from country to country and should be a signpost for policymakers

The study points previous international studies on threshold calculation are not really appropriate for India.

Generalization of the findings of the long-period cross-country studies to India is fraught with conceptual difficulties. This is because such studies on one end included countries with an inflation rate as low as one or two per cent and on the other, those with inflation rates going beyond 200 to 300 per cent. In addition, during last two decades or so, Indian economy has undergone a significant structural transformation. From 1996 to 2002, GDP growth was hovering around 6%, while y-o-y average Wholesale Price Index-inflation was close to 5% (Fig. 1).

Subsequently, growth traversed much higher trajectory and inflation remained relatively low in the range 5-6% till global financial crisis adversely affected growth-inflation dynamics. After the recent global crisis in 2008, growth rate of India bounced back much quicker than anticipated and at the same time inflation went up significantly. Therefore, the dynamics of growth-inflation nexus in India is not straight forward. For a country like India, which has witnessed many structural changes in the past few decades, going back too long may not reflect the current evolving state of the economy. Hence recent data based on quarterly information is a possible alternative.  

With a view to capturing the recent structural changes in the economy, this study used quarterly data from Q1:1996-97 to Q3:2010-11 and empirically explored the existence of an inflation threshold, if any, based on three different approaches indicated above.

International studies show lower threshold levels for advanced and higher for emerging. Despite limitations, there have been some studies on India’s threshold:

Many studies in Indian context have provided differing views on inflation threshold. Chakarvarty Committee (1985) referred to it as the acceptable rise in prices at 4 per cent. This, according to the Committee, reflects changes in relative prices necessary to attract resources to growth sectors. “As growth is not uniform in all the sectors, maintaining absolute price stability, meaning a zero rate of increase in prices, may not be possible and nor is it desirable.” Rangarajan (1998), who pioneered the concept of threshold inflation, brought central bank focus on inflation rate at 6–7 per cent known as “acceptable level” of inflation. His idea of threshold was: at what level of inflation do adverse consequences set in?  

The study by Vasudevan et al. (1998) and, Kannan and Joshi (1998) found the threshold level to be around 6 per cent. Results of Samantaraya and Prasad (2001) are also on similar line as they found the threshold level to be around 6.5 per cent. In contrast, Singh and Kalirajan (2003) using annual data for the period of 1971–1998 provided argument against any threshold level for India. A more recent study by Singh (2010) which used both, yearly and quarterly data, found  threshold level of inflation for India at 6 per cent but failed to confirm the same in Sarel (1996) sense.

They look at three approaches:

• Sarel’s method: 4.0%  – 5.5%
• Khan and Senhadji – 4.7 – 5.5
• Espinoza – 4.5 – 5.5

Hence broadly all three indicate that inflation over 5.5% starts to negatively impact growth. Current inflation levels at 9.5 – 9.75% are almost double of this threshold…

Through these papers, RBI is trying to bring some sanity to the inflation/growth debate. It is ridiculous when experts say that India has to tolerate higher inflation if it has to grow higher.