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Low Inflation Rate may cost a lot for RBI

RBI is targeting an inflation at 4%, and the Consumer Price Index(CPI) based inflation for being at 2.18%, it seems RBI may have to pay a huge cost in maintaining such a low inflation percent.

Because even the absence of interest rate cuts hurts growth.

Any central bank worth its salt should be worried about how much growth it is ready to sacrifice in order to push down the inflation rate to very low levels.

This is particularly true because food prices have a large weightage in CPI and the flip side of deflationary food prices is being seen in farmers’ agitations throughout the country. Note that food prices in May 2017 fell by 1.05% from a year ago.

While it’s a separate argument on what inflation rate is long-term growth-friendly, the central bank is always monitoring something called the “sacrifice ratio”. This ratio is the cost of reducing inflation, the loss of output that must be sustained by the economy in order to achieve a reduction in trend inflation. In statistical terms, it is defined as a ratio of the percentage loss of real output to 1% reduction in trend inflation.

The sacrifice ratio, according to an RBI study in 2015, was lower during periods of contractionary monetary policy than during expansionary ones.

RBI’s Households’ Inflation Expectations Survey shows a declining trend for nearly four quarters now.

The sacrifice in growth by the Central Bank will depend on the prevailing situations.

Gross value-added (GVA) growth at constant prices was already 1.32 percentage points down to 6.6% in the fiscal year 2017 (FY17). The inflation rate was down by 0.41 percentage points to 4.52%.

This makes it look like RBI gave up too much on growth in its pursuit of curbing inflation. In the central bank’s own words, the demonetization impact was transitory and the slowdown is primarily due to decelerating investment demand.

If we take RBI’s real GVA growth forecast of 7.3% for FY18 and assume that the central bank would achieve the 4% inflation target this year, then a loosely calculated sacrifice ratio (assuming the potential growth rate of the Indian economy at 9%) works out to 3.4.

This means that for every one percentage point decrease in inflation, RBI risks destroying 3.4 percentage points of growth. That looks like a high price to pay, but much would depend on what the potential rate of growth actually is and there is little agreement on that.

Nevertheless, the notion of a “sacrifice ratio” does highlight the fact that forcing inflation down below a threshold level has a cost attached to it. And apart from the economic cost, the social cost in the farm sector of deflationary food prices also needs to be kept in mind.

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