Inflation of less than 5.5% can give a fillip to economic growth, a study by the Reserve Bank of India (RBI) has said.
"Empirical results... show that there exists statistically significant structural break in the relation between growth and inflation at 4.5-5.5%... Thus substantial gains can be achieved if inflation is kept below the threshold," RBI's Working Paper said.
The paper, authored by RBI Executive Director Deepak Mohanty and three other officials, found there is a positive impact on growth when inflation is up to 5.5%.
"The relationship reverses when WPI inflation is beyond 5.5% and inflation effect on growth turns negative...," said the working paper 'Inflation Threshold in India: An Empirical Investigation'.
The paper comes at a time when the RBI is under pressure due to the sustained inflationary pressure in the economy.
Headline inflation stood at a 13-month high of 9.78% in August. RBI has hiked its key policy rates 12 times since March 2010 to tame demand and curb inflation.
Experts have said the repeated rate hikes, which have led to an increase in cost of borrowings, a decline in fresh investments and slowdown in the economy.
Economic growth in April-June slowed to 7.7%, the slowest in six quarters. RBI has already revised downwards its growth forecast for the country to 8% in 2011-12, from 8.5% GDP growth in the previous fiscal, and said inflation would act as a dampener.
In the paper, the authors tried to find out if inflation in India has to reach some minimum 'threshold' before growth effects turn adverse.
"The findings clearly suggest that inflation threshold in the sense of structural break point exists for India and this implies a non-linear relationship between inflation and growth," it said.
According to the study, the growth-inflation relationship depends on the rate of price rise.
"... at some low levels, inflation may be positively correlated with growth, but at higher levels inflation is likely to be harmful to growth. In other words, relationship between inflation and output growth is non-linear," it said.
The paper also argues that the concepts of inflation target and inflation threshold are distinct.
"Inflation targeting is a construct of monetary policy making in which a central bank announces a 'target' and then steers its policy tools towards achieving that target. Inflation threshold is a point of inflexion for the growth-inflation trade-off," it said.
According to the RBI paper, inflation threshold need not necessarily be the 'target' of monetary policy.
"The inflation objective or the target level of inflation for monetary policy should be lower than the inflation threshold, considering the existence of significant lags in the transmission of monetary policy measures and the costs of inflation," the paper said.
From 1996 to 2002, the country's GDP growth stood at around 6%, while the year-on-year average Wholesale Price Index-based inflation was close to 5%.
Subsequently, growth went up even as inflation remained relatively low in the range 5-6% "till global financial crisis adversely affected growth-inflation dynamics".
"After the recent global crisis in 2008, growth rate of India bounced back much quicker than anticipated and at the same time inflation went up significantly. Therefore, the dynamics of growth-inflation nexus in India is not straight forward.
"For a country like India, which has witnessed many structural changes in the past few decades, going back too long may not reflect the current evolving state of the economy," the paper, which studied the economic growth and inflation data between 1996-97 to 2010-11, said.
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