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Rediff.com  » Business » What about threshold inflation?

What about threshold inflation?

By N R Bhanumurthy & Dony Alex
March 06, 2007 11:30 IST
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Inflation stood at 6.78 per cent in the first week of February as compared to the Reserve Bank of India's target of 5 to 5.5 per cent for 2006-07. Historical data on WPI inflation shows that in the 1970s, the average inflation rate was around 10 per cent, it was around
8 per cent in the 1980s and 1990s, and has been around 5 per cent in the current decade.

Given this historical trend, one can argue that the current level of inflation is not so alarming. But an important issue that needs to be addressed for overall macroeconomic stability is the issue of threshold level of inflation in the country.

The Chakarvarty committee had presumed the threshold inflation level at 4 per cent, which was supposed to be an "acceptable rise in prices purported to reflect changes in relative prices necessary to attract resources to growth sector".

But this was on the back of the average level of inflation of 8 per cent in the 1980s! This target seems to reflect the argument for achieving absolute price stability, which is possible only in developed economies, as the Indian data itself does not show this level.

Later in the mid-1990s, under C Rangarajan, the then RBI governor, the apex bank focused on what is known as "acceptable level" of inflation rate at 6-7 per cent.

Since then, there was not much discussion on this issue in either policy-making or in academic discussions. One reason could be that after the mid-1990s, the inflation rate might not have touched the "acceptable" threshold.

The present inflation rate is still below the "acceptable" level of inflation rate. But this is making headlines. The issue is whether in a fast growing economy like ours, an inflation rate of 6 to 7 per cent is acceptable - the inflation rate (targeted absolute inflation) in industrialised countries is less than 2 per cent, while most of the developing countries experience nearly double-digit or more inflation.

But for a country like India, which is one of the leading emerging market economies, the acceptable inflation rate is expected to decline compared to the past.

So what is the concept of threshold level of inflation? The relation between inflation and growth has been a long drawn debate in macroeconomic management, but the precise definition regarding the acceptable or threshold level has been quite ambiguous.

Threshold level of inflation can be described as that inflexion point beyond which the output growth is not optimal. Empirical studies have shown that at inflation rates higher than threshold level, the output growth has retarded.

We have undertaken an econometric exercise to examine the threshold level of inflation for India. Although inflation could be caused by supply-side constraints, which are mostly short-term phenomena, it is believed that long-run stability in inflation could be brought majorly through active monetary policy. Our econometric results based on monthly data in the post-reform period show that the threshold inflation rate is within 4 to 4.5 per cent for India. Beyond this level, inflation is growth retarding.

We have been predicting for quite some time that the year-end inflation would be above the RBI's targeted level. We have also suggested that due to some strong cyclical reasons transmitted through international factor movements, the current interest rate cycle would peak by the end of 2006.

Although the RBI has undertaken tight monetary policy in a gradual manner, which led to current rise in overall interest rate structure, we feel that these moves are rather hesitant. In other words, the current high inflation rate could be attributed to the hesitant monetary policy stance that the RBI had adopted in this financial year. This must have led to over expectations and could have been one of the reasons for so-called "over heating" that is being talked of by analysts.

The writers work with the Institute of Economic Growth, Delhi.
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N R Bhanumurthy & Dony Alex
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