Sustainability of Economic Growth and Controlling Inflation: The Way Forward
(Address by Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India at FICCI's
National Executive Committee Meeting at Mumbai, April 5, 2011)
It is my pleasure to speak at FICCI’s National Executive Committee Meeting this year. As many observers have been highlighting, after a relatively long phase of benign, growth‐friendly macroeconomic conditions, things have begun to look somewhat hostile on the macroeconomic front. The most significant manifestation of this is the acceleration of inflation, a trend that was visible even before the impact of the financial crisis was felt in late 2008, but which very quickly and strongly re‐emerged as the economy began to recover in the second half of 2009‐10. Despite significant actions on both policy rates and liquidity by the Reserve Bank, inflation remains high, giving rise to some very fundamental questions: is this high rate of inflation, previously believed to be unacceptable, now the new normal? Is it an unavoidable price to pay for sustaining the current growth trend? Or, will it actually work to
undermine the sustainability of the current trend?
Before arriving at a firm policy position on this issue, we must examine all the risks associated with persistently high rates of inflation over relatively long periods of time. In this address, I propose to do three things:
1. Examine the growth‐inflation dynamics in the Indian economy over the past couple of decades to see if any patterns can be discerned;
2. Examine the drivers of the recent trends in inflation and relate them to underlying growth drivers;
3. Present some key issues and concerns that I believe should influence our policy thinking.
The Growth‐Inflation Relationship in India: The Post‐1991 Experience Slide 1 displays the trajectories of growth and two indicators of inflation over the past two decades – the Wholesale Price Index (WPI), reflecting headline inflation and the Non‐Food Manufacturing component of it. In our policy framework, we see the latter as a measure of ‘core’ inflation – that which is driven by demand side pressures. A number of patterns emerge that might provide a useful backdrop to the discussion of what lies ahead.
First, we do see a striking contrast between the two episodes of high growth that the economy experienced after 1991. During the first episode, 1994‐95 – 1996‐97, both measures of inflation ran relatively high. In fact, the growth began to accelerate in the midst of an already uncomfortable inflationary environment, reflected by both the headline and core measures. The proximity between the two suggested that demand pressures were predominant. In this scenario, the only way that inflation would come down would be through demand compression and that is indeed what happened. An anti‐inflationary monetary stance combined with a shock to exports in the wake of the East Asian crisis and a bad monsoon achieved this. Over the next few years, both growth and inflation rates were relatively low.
The second high‐growth episode began in 2003‐04 and, with the exception of the slowdown during the crisis period, is still continuing. However, from the inflation perspective, this episode itself has two distinct segments. In the first few years, high growth was accompanied by low inflation, both headline and core. On the eve of the crisis period, both indicators increased significantly, suggesting the emergence of demand‐side pressures. During the brief slowdown, both inflation indicators dropped sharply, but core fell far more than headline, indicating that supply‐side pressures were now visible. The resurgence of inflation over the past year is the result of both demand and supply forces, as can be seen from sharp climb in both inflation indicators and the persistent gap between them.
One impression from the contrast between these two episodes is that growth in a low‐inflation environment can be more robust and enduring. This is partly because monetary policy can afford to accommodate growth by keeping interest rates low. However, as we saw, even in the more recent episode, demand pressures were driving inflation up, which saw the monetary policy stance, which I shall discuss in somewhat more detail later, reverse course during that period. A second observation, relating to recent developments, is that, while supply‐side pressures have clearly impacted headline inflation, the relatively brief and shallow slowdown did not fully eliminate demand‐side pressures from the system and these too have contributed to the recent behaviour of inflation.
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