The RBI Governor’s reported statement intending to revisit the theoretical framework of the oft-stated sustainable inflation level of 4.0-5.5% prompts the question: Why is India’s inflation, in relation to its actual or potential growth, continuing to remain persistently high, while many of our emerging market (EM) peers seem “apparently” to have lower inflation? After all, almost all emerging economies face the same global commodity prices as inputs, and the increasing turnover on domestic commodities exchanges also serve to transmit global prices to domestic.
First, is the perception correct at all? The accompanying table shows the growth-inflation profiles of some EMs, a crude measure of Phillips Curve trade-offs. The intent is to highlight the level of inflation relative to growth, rather than just the absolute levels of inflation. Two patterns emerge. One, adjusting for growth, India’s inflation does not look completely out of line compared to at least some of the other EMs in terms of differentials between CPI inflation and GDP growth. Two, it does seem that the selected countries are clustered into two broad groups with high and low inflation differentials. Might there be some underlying macroeconomic reason for this behaviour? Note that the three countries with the higher inflation differentials were also those with the worst performing domestic currencies (see graph), indicative of large current account deficits, which will affect the extent of pass-throughs of global commodity prices.
For the moment, set aside domestic factors (aggregate demand, capacity utilisation levels, etc), even measurement issues (i.e., our own year-on-year change versus the annualised month-on-month change methodology using deseasonalised data used in some of our EM peers). Many hypotheses have been put forth for the different extent of pass-through, in terms of the openness of the respective economies, the degree of dependence on external energy sources, the movement of the domestic currency against predominantly the US dollar (in turn a reflection of macroeconomic imbalances, particularly current account deficit). But there has been no systematic attempt to understand the underlying drivers of the differential pass-through.
An IMF paper published recently* helps in providing an analytic scaffold of this differential, by relating inflation to a