If the country then chooses an inflation target that is lower than the threshold level, it cannot achieve its potential output growth and the system would remain in long-run disequilibrium requiring constant policy interventions to stabilise,” says a paper by the Development Research Group, an RBI-backed independent research initiative.
According to the study, India’s threshold consumer inflation — a level beyond which price rise hurts growth — is 6%. Currently, the flexible inflation target is 4% that can move 2 percentage points either way.
The research led by Ravindra Dholakia, the former MPC member with a dovish view, comes soon after the government reiterated the same level of inflation target despite strong arguments to raise it.
“The findings of the present study caution the policymakers not to ignore the probable cost of lower inflation in terms of lower longterm growth of output and employment and a hence lower rate of the poverty reduction,” it said. “These costs and benefits of fixing a long-term inflation target will have to be considered while making the choice.”
But the findings of the study also show that the threshold inflation and corresponding growth depends on the other two parameters — the ratio of fiscal deficit to GDP and current account deficit to GDP.
The study estimates the trade-off between long-run inflation and steady-state growth rate. The gain in growth would be 15 basis points for a 100 bps reduction in inflation towards the threshold level. A 100 bps reduction in inflation from the threshold could result in a 40 bps loss in growth. “Even in the latter case, it would take more than two decades to recover the cost of sacrificing GDP to bring down the equilibrium rate of inflation,” it said.