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Is low inflation the culprit for India's economic woes?

​​The sparse attention paid to the past monetary policy mistakes in understanding current slump is surprising.

Updated: Sep 19, 2019, 06.21 AM IST
By Abheek Barua

The relatively sparse attention paid to the role of past monetary policy mistakes in understanding the roots of the current slowdown is surprising.

A closer scrutiny of recent monetary history offers better clues to the growth puzzle than hypotheses like demand saturation or changing consumption habits of millennials. Also, the tenure of the new RBI governor that started in January this year has seen a shift away from some of the policy practices that had evolved since 2011. A revised policy framework should help formalise this eminently sensible shift.

But why monetary policy? For one thing, much of the economy’s current woes stem from the ‘nominal effect’ — the fact that growth in the current money values of stuff like GDP growth or consumption expenditure petered out.

Thus, the fact that the current money value of GDP growth slowed down to just 8% for Q12019-20 (the lowest growth since 2002-03, if different GDP series are blended) is, perhaps, a little more alarming than the slowdown in real growth to 5%.

Crudely put, nominal or GDP growth at current prices is the sum of real growth and price increase or inflation. The deceleration in inflation is as much of a worry as the real growth in output. GDP deflator inflation, the relevant index of inflation, was incidentally just 2.8% in this quarter, and declined steadily over the past fiscal year.

Managing inflation is RBI’s remit. So did RBI, over the past few years, deal with inflation with too heavy a hand? Do we need to rethink the entire business of inflation targeting as it emerged over the past years?

The link between inflation and growth is well established. Any student who has endured even an introductory course in macroeconomics would remember the Phillips curve that argues that inflation and growth move together and in the same direction.

Economists qualify this by claiming that this inverse relationship holds only in the short run. How short? In real life, where the leads and lags between different economic variables remain intractable, can we afford to ignore the collateral costs of monetary hyper-vigilance & hope that a golden long term emerges where low stable inflation accompanies high growth?

There are more immediate and visible costs of low inflation. Tax collections depend on nominal GDP growth — lower the latter, higher the chance of missing tax collection targets forcing GoI to slash expenditures to meet fiscal targets. Surveys show that salary and wage increase for corporate India has increasingly been indexed to official inflation data.

Thus, the annual increase in salaries has barely been in double digits over the last three years. Although low inflation means that a smaller salary increase can (at least in theory) buy the same amount or more, individuals tend to suffer from the ‘poorness illusion’. This discourages them from spending, particularly on big-ticket items like cars and consumer goods.

Again, low inflation means a high real interest rate that, in turn, tends to crimp investment activity. For the last couple of years, this real rate measured as the difference between the repo rate and inflation has averaged over 4%. The boom period for investment between 2005 and 2007, incidentally, saw an average of a just a little over 1%.

This is not to suggest we didn’t need a stern monetary response to the sharp increase in inflation at the beginning of the decade. 2011-13 saw mean inflation close to double digits, with a peak of 11.5% in between. This was clearly unacceptable. RBI raised rates sharply and this paid off with a little help from soft oil prices. Inflation came down to an average of 4.6% in H2 2013-14.

But questions must be asked about the inflation paranoia that followed. First, while a declared nominal anchor for inflation set in a broad range of 2-6% was desirable, should RBI have fixated on willy-nilly getting to a stable inflation rate of 4%? In fact, is a higher long-term inflation target compatible with our growth aspirations?

Did the flexible inflation targeting model adopted in 2016 fixate entirely on inflation and actually tamp down growth impulses? Did RBI factor in inflation blips driven by temporary supply shortages in its bid to keep headline inflation in check, instead of ‘seeing through’ them?

Also, did the new regime at Mint Street rely too mechanically on a forecast model that tended to go wrong? Was there a really a need to have long periods of liquidity shortage? More fundamentally, is the old multiple indicators approach that allowed more discretion better suited to our needs than a rule based inflation targeting framework?

Growth seems to be back as a central agenda for RBI. The policy rate has been cut sharply and banking liquidity is in surplus. RBI must signal that this strategy is here to stay, until we climb back on to a higher trajectory for both inflation and growth rate. This would alleviate the financial sector’s anxiety that the punch bowl might be suddenly snatched away.

The writer is chief economist, HDFC Bank. Views are personal
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of
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