We have been reporting a lower rate of inflation for some weeks now and some economists have already started expressing worries about the growth consequences of deflation. Some analysts at the Reserve Bank of Indias Department of Economic Policy and Analysis have made much of a muchness about this in this years Report on Currency and Finance, and have already been upbraided by two of our distinguished columnists this week for their mechanical interpretation of the notion of a threshold rate of inflation and the trade-off between growth and inflation.
Some commentators regard the views expressed in the RBI report as a green signal from the central bank to a fiscally pressured finance minister. That is a gross misreading. It should be straightaway pointed out that the views expressed in the Report on Currency and Finance are not the official views of the central bank. The Report on Currency and Finance is more of an academic document, not a policy document vetted and authorised by the governor of the Reserve Bank and its key policymaking deputy governor.
More to the point, in the debate on the trade-off between growth and inflation, it is useful to remember that we do not have in India a unique rate of inflation. It is said that opinions can differ, but facts are supposed to be sacred. Unfortunately with inflation data in India, facts also differ. There are many measures of inflation wholesale, consumer, urban, rural and many rates point-to-point, annual average, headline rate and, for politicians and housewives, a household rate. Inflation targeting is a mugs game.
There are, however, some issues which need to be clarified before someone in North Block or Yojana Bhavan gets carried away and starts believing that RBI has given its imprimatur for a liberal fiscal and monetary policy, having conceded that there is indeed a trade-off between inflation and growth and that a little bit of inflation is not such a bad thing. There is no better guide on this subject than the views expressed by former RBI governor C Rangarajan in three different essays. After all, many of the authors of this years RBI Report on Currency and Finance have been tutored on the subject by Dr Rangarajan!
The first and second entitled, Dimensions of Monetary Policy and The Changing Context of Monetary Policy are published in his Indian Economy: Essays on Money and Finance (UBSPD, 1998). The third is his Sukhamoy Chakravarty Memorial Lecture, entitled Some Critical Issues in Monetary Policy, delivered in 2001 and published in the Economic and Political Weekly (June 16, 2001).
Dr Rangarajan reminds us that the Sukhamoy Chakravarty Committee on the working of the monetary system (1985) had suggested at that time that a 4 per cent rate of inflation was an acceptable rise in prices reflecting changes in relative prices necessary to attract resources to growth sectors. On his part, Dr Rangarajan had taken the view in 1997 that a 5 to 6 per cent rate of inflation was the upper ceiling acceptable at that point but that policymakers must endeavour to bring it down to a more acceptable level.
This tolerable ceiling was defined against the background of a prevailing 10 per cent rate of inflation in the first half of the 1990s, against the long term average of around 8 per cent. The 5 to 6 per cent acceptable rate was defined against a prevailing 10 per cent rate and in the context of global trends and Indias level of integration with world markets. Given that global inflation has trended down, and that the rate of inflation in countries that compete with India for a share of the world market, especially China, is below the rate prevailing in India, the acceptable threshold rate in 2002 could be quite different.
In the Sukhamoy Memorial Lecture, Dr Rangarajan offers a more elaborate theoretical discussion of what is a threshold level of inflation and whether there is a trade-off between growth and inflation. He draws our attention to what economists have come to define as the Taylors rule, which prescribes that the signal interest rate be fixed taking into account the deviations of inflation rate from the target and actual output from its potential. Says Rangarajan, In this rule, the coefficient of inflation deviation term is fixed at a level higher than unity. While the rule is intuitively appealing, there are serious problems in determining the value of the coefficients. In this context, the critical question to answer is: at what level of inflation do adverse consequences begin to set in It is this inflation threshold which will provide some guidance to the policymakers. Below and around this threshold level of inflation, there is greater manoeuvrability for the policymakers to take into account other considerations.
The more important point made by Dr Rangarajan pertains to the role of globalisation and Indias increased exposure to the world economy. A domestically acceptable rate of inflation cannot be out of line with global trends, particularly inflation in our trade rivals like China. Chinas near zero inflation rate is also a threshold of sorts!
Furthermore, the growth-inflation trade-off must be viewed in the context of what is driving inflation down. If it is subdued by a tight monetary policy or by fiscal conservatism then there is a margin left for fiscal activism and monetary liberalism. If however, structural factors are keeping prices down, aided by falling oil prices and a good monsoon, where is the freedom to instrumentalise the trade-off between inflation and growth through fiscal liberalism
Finally, in an already demand constrained economy, with employment and incomes restrained by low growth, reflation can worsen income inequalities and reduce export competitiveness in the short term. So it is best to nip the reflation idea in the bud before it captures the finance ministers imagination.