What should inflation be?

The Reserve Bank of India (RBI) has been maintaining for the last few years that its job is to ensure an inflation rate of between 5 per cent and 5.5 per cent. That sounds comforting, and the Bank is probably right in aiming low. Nevertheless, it seems worthwhile to ask: where did this rate come from? Why not 2.5 per cent, as recommended by Milton Friedman in his famous 1948 paper on monetary stability? This is the inflation rate which China and the western economies enjoy, and the Chinese have double-digit growth to boot. Or why not 4 per cent inflation, as recommended by the Sukhumoy Chakravarty Committee in 1986? In other words, no one really knows what the 'right' rate of inflation should be. However, everyone knows that it should be low "" but not 'too' low, and certainly not zero. So by some sort of heuristic process, the financial world seems to have arrived at a consensus "" inflation should range between 2.5 and 5.5 per cent. Beyond that lie the shoals.

Whatever inflation range you take as desirable, today's inflation rate lies outside the bracket. So what is one to do? The trade-off is usually posited between growth and inflation. All of industry wants to make sure that the growth momentum is not affected by anti-inflation measures, and the finance minister seems to share that concern. There are even those who might argue that 9 per cent growth with 7 per cent inflation is a better option than 6 per cent growth with 5 per cent inflation (in their view, we should tilt the scales in favour of growth). Others would ask why there should be such a trade-off at all, when China pulls off double-digit growth with 2 per cent inflation. Conventional economists, reflecting the received wisdom of all the theoretical work done in the field and the practical experience around the world, would argue (as Dr Reddy did this past week) that low inflation is good for sustained growth, and high inflation will end up necessitating harsher anti-inflation steps tomorrow, thus hurting growth (the 'stitch in time...' argument). Indeed, some believe that Dr Reddy should have done more by now, in terms of raising interest rates, and we are paying the price for the RBI's soft-pedalling of the issue through 2006.

To cap it all, it is now received wisdom amongst central banks that they should behave like the old naval semaphorists. Central banks 'signal' their messages in what are called 'baby steps'. This means we get tiny increases or decreases in the interest rate. This may suit the high-rollers on the financial markets because it gives them the time to adjust their portfolios. But, the argument goes, that very process may deprive it of the shock effect that may be required to change inflationary expectations "" which, some argue, is at the heart of the issue.

What if the inflationary conditions are because of supply shortages in sectors that do not respond to monetary policy changes, such as agriculture or infrastructure or commodity imports like crude oil? Where does that leave the effectiveness of monetary policy in tackling inflationary trends? In India there is black money as well, which plays a substantial role in trade credit. For all one knows, this may be largely impervious to what happens in the formal money markets. If this be so, it reduces the effectiveness of monetary policy. In other words, inflation control goes beyond monetary policy, and many of the solutions lie with the government and not with the central bank. For starters, how about reducing the fiscal deficit a little more than is on the cards just now?