Central banks all over the world (India included) posit that there is a potential trade-off between growth and inflation in the sense that inflation at low levels is beneficial for growth. However, at higher levels/beyond a threshold level, inflation can be inimical to growth. In the Indian context, the threshold inflation estimated for the period 1970-71 to 1999-2000 is 5% (RBI estimates). This means that at inflation rates beyond this level, growth is impacted adversely. Alternatively, attempts to reduce inflation beyond this point would necessitate a reduction in output. However, in recent times, RBI itself has clarified that in view of the changing economic scenario and rigidities in inflation rate, the threshold inflation rate may be revised (December 2, 2012, RBI Governor).
One logical corollary of the short-run trade-off between inflation and output is that a sacrifice of output is inevitable in the pursuit of inflation reduction. This loss of output is referred to in the economic literature as the sacrifice ratio. There are several estimates of sacrifice ratios for developed countries, but for developing countries, such estimates are limited (see table). For example, for 19 OECD countries during 1963-1997, the sacrifice ratio was on an average 3.2: for most of the countries, the ratio lay in a range of 2-4, although outliers1.6 (Japan, Italy and the Netherlands) and 7 (Norway)were also observed.
RBI has estimated that, for India, the sacrifice ratio turns out to be almost 2 over the period 1975-2000. This effectively implies that a reduction in the inflation rate by 1 percentage point would require a reduction in output by 2 percentage points from its potential level. This means that statistically, if the inflation rate were to reduce from the current level of 7.18% (December 2012) to the acceptable 5% level, output would actually witness a de-growth from the current level of 5.3% (GDPQ2 estimates). Thus, the losses in macroeconomic welfare of a potential reduction in inflation are perceived to be significant, if we purely go by the sacrifice ratio estimates.
However, two contrasting issues are important here. First, several pieces of evidence suggest that sacrifice ratios tend to increase significantly (for example, by 75% for a group of developed countries where inflation dropped from 8% to 3.5%) in periods of declining inflation. In such a situation, a tightening of monetary policy would have stronger real effects than in the past. Second, the trinitysupply-side responses, domestic fiscal rectitude and global environmentwill continue to act as exogenous constraints on the endogeneity of monetary policy conduct, particularly for a developing country like India. In such a situation, the trade-off between growth and inflation will have little significance and the concept of a sacrifice ratio may lose all relevance.
How are these two issues relevant for India With the inflation rates currently declining (core inflation declining to a 36 month low in December 2012 to 4.2%), we believe that there could be a strong possibility of an increase in the sacrifice ratio from the earlier postulated value of 2. To test this hypothesis, we estimated the sacrifice ratio beginning 2009 on a quarterly basis for India. The results indicated that there was a significant jump in the sacrifice ratio (Q4FY08-Q2FY13). Interestingly, while it may be reasonable to assume that such a trend is in conformity with historical evidences, a correct diagnosis could be that such a high sacrifice ratio is not statistically significant, pointing to the fact that exogenous factors might have pushed the sacrificed ratio higher.
Thus, the evidence of a high sacrifice ratio post 2009 is possibly explained by the fact that the postulated growth-inflation trade-off may not be relevant in the current economic scenario. In fact, a study by NCAER shows that the correlation between CPI inflation rate and GDP per capita growth rate for the period 1970-71 to 2010-11 is only minus 0.11. Based on a panel data on inflation (CPI) and per capita GDP data for emerging economies during 2001 till 2010, we found that the postulated evidence of a negative causation is not particularly strong, with a correlation coefficient of minus 0.31.
This supposedly weak link between growth and inflation, we believe, may be explained by the influence of exogenous constraints on monetary policy conduct outside the realm of RBI. Such factors remind us of the classic policy trilemma (the ability to accomplish only two out of the three policy objectivesfinancial integration, exchange rate stability and monetary autonomy) still remains a valid macroeconomic framework. We will take up these factors in the part two of this essay.
This is the first of a two-part series
The author is Director-Economics & Research, FICCI. Views are personal