Posted by: Deepa Vasudevan on Thu, Nov 1st, 2012
The Inflation Growth Balance
The Inflation Growth Balance
The RBI released the Q2 FY13 review of monetary policy on Oct 30. Interest rates were not changed, but the Cash Reserve Ratio (CRR) was cut by 25 basis points. The stated purpose was to enhance liquidity and credit flow without creating further inflationary pressures. But financial markets, which had been desperately hoping for an interest rate cut, responded negatively. Bond and stock prices fell, and even the Finance Minister publicly expressed disappointment.
Two divergent points of view are being expressed in post-policy discussions.
(i) Interest rates should have been reduced to spur growth. If repo rates were cut, banks would have passed it on by reducing their lending rates. This, in turn would stimulate investment (lower cost of capital for industry) and consumption (lower costs of home and car loans). Market sentiment would improve, making it easier to raise capital. As a result GDP growth would increase.
(ii) Interest rate reductions can be inflationary. Inflation- both general and core- continue to be higher than RBI’s comfort level. Rising demand can trigger off more inflation. So it is prudent to provide liquidity through CRR cuts, while keeping interest rates under control.
These views represent two sides of the inflation-growth trade-off. Popular belief is that monetary policy has to choose between stimulating growth and reducing inflation. Interest rate changes benefit one variable at the cost of the other.
However, the relationship between inflation and growth is asymmetric. Low levels of inflation benefit growth, by keeping wage and price hikes under tolerable levels. But beyond a certain threshold level, inflation starts eroding incomes and purchasing power significantly. Wages need to be raised to match inflation. This puts an upward pressure on final prices, and the classic wage-price spiral is created. Uncertainty about further price rise forces a postponement of investment decisions. Household savings reduce, and whatever can be saved goes into physical assets such as gold and property. At these levels, inflation hurts growth.
Economists generally agree on the non-linear relationship between inflation and growth. The problem is in identifying the exact threshold level at which inflation changes from useful to counter-productive. Recent research in RBI places India’s threshold inflation between 4%-5.5%*. Theoretically, sustained inflation beyond that level should retard growth.
The picture below plots real GDP growth against WPI inflation for India over the period 1992-93 to 2011-12. We slice the scatter plot into two parts assuming a threshold inflation of 5.5%. At levels of inflation below the threshold, there appears to be a positive link between inflation and growth. At higher levels, the reverse happens. From the evidence of the past two decades, it is clear that a low inflation environment facilitates growth, and a high-inflation environment retards the forces that create growth.
Real GDP growth versus Inflation
But inflation is only one of the many variables, both domestic and international, that impact GDP growth. In 2009-10, for instance, despite the global financial crisis, a strong fiscal stimulus pulled growth to 8.4%. In 2002-03, despite very low inflation, a severe drought brought GDP growth down to 3.8%. During the high growth phase of 2003-08, inflation was in the range of 4%-7%, and other macro-economic factors were favourable too.
Thus monetary authorities have to examine several variables before tinkering with interest rates. The RBI has pointed out two downside risk factors to domestic growth. First, global economic conditions need to improve. Second, recent policy announcements that aim at fiscal prudence need to be translated into action. Until these uncertainties remain, the best RBI can do in terms of monetary conditions is to ensure adequate liquidity (via CRR and open market operations) and funds availability. And of course, ensure that inflationary expectations stay low. These objectives have definitely been achieved.
* "Inflation Threshold in India: An Empirical Investigation", by Deepak Mohanty, A.B.Chakraborty, Abhiman Das and Joice John, RBI Working Paper WPS(DEPR): 18/2011, Dept of Economic and Policy Research, Sept 2011