How much inflation is good for growth

March 22, 2014

(Any opinions expressed here are those of the author and not of Thomson Reuters)

The RBI has left it to the government to decide the inflation target since it considers it politically sensitive. The central bank will accordingly modulate its monetary policy to ensure that the government’s target is not exceeded.

Targeting inflation alone cannot be the sole objective of monetary policy, though it is an important criterion for regulating the repo rate. Even developed countries have concerns about inflation – when it is too low or too high.

In the wake of the financial crisis of 2008, the sole objective of the U.S. Federal Reserve was to rev up the economy, and it used quantitative easing to pump in dollars so that the economy was flooded with cash.

Part of the overflow leaked into emerging market economies and increased inflation there. But it did not lead to inflation in the United States. Nevertheless, it helped keep interest rates low, which was expected to promote investment and consumption. More than inflation, the Federal Reserve targeted unemployment with the objective of pushing it down below 7.5 percent. That did happen, but only after five years.

Inflation has also been low in Japan and Europe, leading to low growth. Abenomics (the economic policies advocated by Japan’s PM Shinzo Abe) more or less followed the Federal Reserve model of quantitative easing to lift Japan’s economy, but the stimulus has not been strong enough to push up inflation. The European Central Bank has also lowered interest rate to generate demand and increase inflation.

The danger with low inflation is that it can silently push the economy into recession. That is what Japan experienced over long periods. The objective behind pushing up inflation is to revive growth. Inflation by itself is not the cause of growth, but it can be an indicator of excess demand, which is necessary for growth.

India’s present concerns are of a different kind. Inflation is too high and instead of providing stimulus to the economy, it has actually weakened growth. The jump in inflation from 4 percent to 9 percent dragged growth down from 9 percent to 4.7 percent. Inflation beyond a point can be as detrimental to growth as inflation below a level is.

It is generally accepted that 3 percent inflation is just enough to stimulate growth and prevent the economy from sliding into recession. At that level, repo will be about 5 percent and interest on bank credit 7 percent. This combination will be ideal for growth with relative stability, provided other components of growth are in place.

What about political susceptibility of inflation? The government has expressed concern only when inflation exceeds 5 percent. It would appear that inflation below 3 percent may hurt growth and above 5 percent may not be politically acceptable. The inflation target for the RBI should be in the range of 3 to 5 percent to balance growth and consumer concerns.

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Inflation, no inflation duh. Just give us some food, proper roads to walk on and some good news to read in the newspaper.

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