India should initiate disinflation while the going is good.
There is a pervasive belief that inflation can be reduced only at the cost of giving up growth, despite evidence to the contrary. A major determinant of results as seen in other countries is the policy mix and instruments used to reduce inflation and promote growth. The key to effective solutions appears to be identifying causes and formulating effective solutions with minimal negative consequences, not rote responses. This applies to managing capital inflows, too.The RBI published a study in 2003 on the estimated loss of output for reducing inflation in India.* The report calculates the sacrifice ratio, defined as the loss in output (or employment) for a 1 percent reduction in inflation as a deviation from the trend GDP. The report presents a survey of the literature together with data from India, with estimates of losses for disinflation. While the report acknowledges that lower inflation rates would be most beneficial in the long term, it argues that such efforts reduce GDP growth. The report estimates India’s sacrifice ratio using the WPI inflation rate for the period 1970-71 to 2000-01 at 1.9-2.7 for each percentage point reduction in inflation. Using the GDP deflator, the sacrifice ratio is estimated at 2.6-3.5. An earlier report by the RBI in 2002 based on the WPI estimated the sacrifice ratio at 2.Perhaps a limitation of these studies was their consideration of OECD data, and not data for developing countries. With the extent of India’s growth since then, it would be interesting and useful to know if the RBI has done more research in this area.
There are contrary data from developing countries as well as some developed countries. The IMF’s World Economic Outlook, May 2001, noted that in countries that used inflation targeting for several years (Chile and Israel among emerging markets, and Australia, Canada, Chile, Finland, New Zealand, Spain, Sweden, and the United Kingdom), the sacrifice ratio was estimated at 0.6. For emerging market countries that adopted inflation targeting for two years (Brazil, Colombia, Korea, Mexico, and South Africa), the average sacrifice ratio was slightly negative (-0.4).** Both figures are substantially lower than benchmark estimates for sacrifice ratios in advanced countries.A report by the Central Bank of Turkey in 2002 found that contrary to expectations, there was no significant loss of output for disinflationary episodes in Turkey. *** Inflation, growth and unemployment in Turkey since 2000 are shown in Figure 1.