The current 6 percent upper bound of the Reserve Bank of India’s (RBI) inflation mandate will need to be estimated again once the output gap closes, according to the central bank’s deputy governor, Michael Patra.
In an article published in the May 14 edition of the Economic & Political Weekly, Patra and his co-author Indranil Bhattacharyya, a director in the RBI’s monetary policy department, wrote that estimates for several economic parameters, such as the natural real interest rate, had undergone changes and needed to be updated.
“India’s inflation target of 4 percent is in alignment with trend inflation right up to 2019-20. As data points for the pandemic period form, this estimate will have to be updated along with those for the natural real rate of interest that was placed in the range of 1.6-1.8 percent in the pre-pandemic period,” Patra and Bhattacharyya wrote.
“Likewise, estimates of threshold inflation—beyond which inflation retards growth—which worked out to 6 percent in the pre-pandemic period, will also need re-estimation as the output gap closes,” they added.
Threshold inflation is that level of inflation beyond which the rate of price increases is detrimental to growth. The output gap is the difference between an economy’s actual output and what it can potentially produce. The output gap is said to be currently negative.
The article did not mention or indicate whether a re-estimated threshold inflation rate could be higher or lower than 6 percent.
The article by Patra and Bhattacharyya—which does not reflect the views of the RBI—comes at a time when India is battling sustained high inflation.
Data released on May 12 showed Consumer Price Index (CPI) inflation rose to a 95-month high of 7.79 percent in April, the 31st consecutive month in which it had come above the RBI’s medium-term target of 4 percent. More recently, on May 17, commerce ministry data showed wholesale inflation increased to 15.08 percent last month, the highest in three decades.
Expectations of a sharp increase in inflation in April had forced the RBI’s Monetary Policy Committee to meet more than a month in advance of its scheduled meeting in June and announce a 40-basis-point hike in the repo rate on May 4.
RBI’s research had shown India’s threshold inflation to be 6 percent, so it was adopted as the upper bound of the inflation mandate formally adopted in 2016 as part of the flexible inflation targeting framework.
The RBI’s Report on Currency and Finance for 2020-21 had said it was crucial to precisely estimate the threshold inflation rate to set the upper bound of the flexible inflation target. As per the report, while research had shown India’s threshold inflation rate was between 4 percent and 7 percent, updated estimates found it to be in the range of 4 percent and 5 percent for the period April-June 2002 to January-March 2020.
A longer sample period starting April-June 1997 and ending in January-March 2020 led to the threshold inflation rate being estimated at 5-6 percent, the Report on Currency and Finance said.
“As the concept of threshold inflation applies to the long run and growth is unambiguously impaired when inflation crosses 6 percent, it is recommended that 6 percent be maintained as the appropriate upper tolerance limit for India’s inflation target to remain credible,” the report had recommended in February 2021.
The government, on March 31, 2021, retained the inflation target at 4 percent in a range of 2-6 percent. The target is for a period of five years and will be next reviewed towards the end of FY26.
Some of the other parameters the article by Patra and Bhattacharyya said had already seen changes in recent years include estimates of the exchange rate pass-through to domestic inflation.
According to the duo, prior to the pandemic, India’s exchange rate pass-through was estimated to be 15 percent. This means a 1 percent change in the rupee’s exchange rate versus the dollar resulted in a 15-basis-point change in CPI inflation.
“…but this has been declining since 2014. Estimates incorporating pandemic period data show that ERPT (exchange rate pass-through) has fallen to 8 percent,” Patra and Bhattacharyya wrote.
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