Inflation at 5 per cent may be the acceptable threshold limit in the Indian context and "if it crosses the limit, we have to take note of it and take corrrective measures, as economic growth will be affected," according to C. Rangarajan, Chairman of the Economic Advisory Council to the Prime Minister.
He made the observation while delivering the P.R Brahmananda memorial lecture in Gitam University at the annual conference of the Indian Economic Association here on Friday.
He said that "one way of reconciling the conflicting objectives of price stability and economic growth in the short run is through estimating the threshold limit of inflation. Below and around the limit, there is room for policy-makers to take into account other considerations."
He added that, according to some studies, the threshold limit may be a little higher than he indicated… it may be around 6 per cent. "Individual judgment is involved, as the econometric models are not in a position to capture all the costs of inflation."
He said the policy-makers in India should note that this "level of inflation is higher than what the industrial countries are aiming at. This will have some implications for the exchange rate of the currency. While an open economy helps to overcome domestic supply shocks, it also imposes the burden to keep the inflation rate in alignment with other countries."
He said India had experienced three years of high inflation of above 7 per cent (since November 2009), and even though the position had eased a bit it was a still a matter of concern.
"The repo rates were raised 13 times during the period, largely in baby steps of 25 basis points every time. Perhaps, a sharper increase earlier could have been attempted. Nevertheless, the policy was in the right direction. The signal for reversal of the policy will be when headline inflation and core inflation show definite signs of decline."
Referring to food inflation, Rangarajan remarked that "one factor which stands out prominently in our recent inflation experience is the persistence of food inflation. While changes in monetary policy cannot have a direct impact on food inflation, it can have a moderating influence through containing overall demand pressures. However, if the persistence in food inflation leads to generalised inflation, monetary policy has to necessarily intervene."
In conclusion, he said that "even though one may not fully agree with Milton Friedman's statement that inflation is always and everywhere a monetary phenomenon, one cannot deny that monetary factors play a key role in determining inflation. Therefore, the central banks in developing economies have to bear in mind the primacy of price stability as an objective of monetary policy. Our own experience in the past three years is a clear reminder of it."