'Inflation target rate should be below threshold'

The target inflation rate for monetary policy operations should be set below the threshold inflation level to provide supportive environment for economic growth, according to a study by the Reserve Bank of India (RBI).

For wholesale price index (WPI)-based inflation up to 5.5 per cent, there is positive impact on growth. The relationship reverses when WPI-inflation is above 5.5 per cent. Then, the effect of inflation on growth turns negative.

The central bank on Monday released a working paper, ‘Inflation Threshold in India: An Empirical Investigation’, authored by, among others, executive director Deepak Mohanty. The study took into account the period between the first quarter of 1996-97 and the third quarter of 2010-11.

The target level of inflation should be lower than the inflation threshold, considering the existence of lags in the transmission of monetary policy and the costs of inflation. There is a structural break in the relation between output growth and inflation in between four and 5.5 per cent of inflation (threshold level). The substantial gains can be achieved if inflation is kept below the threshold.

The authors argued the concepts of inflation target and inflation threshold were distinct ones. Under inflation targeting, the central bank announces a ‘target’ and manages its policy tools to achieve that target. Inflation threshold, on the other hand, is a point of inflexion for the growth-inflation trade-off, the RBI study said.

High output growth and low inflation are among the important objectives of macroeconomic policy.