'Economy is not overheating'

Don't mistake the current inflation for a sign of the economy overheating, says Dr C. Rangarajan, Chairman, Prime Minister's Economic Advisory Council.

Speaking on ‘Some Perspectives on Growth and Inflation' at a seminar organised jointly by the RBI Staff College, Chennai and the Madras School of Economics, Dr Rangarajan pointed out that the rise in prices was due to shortage of food (of foodgrains in 2009-10 and of vegetables, milk and eggs in 2010-11). The inflation observed in the last two years is therefore due to the cost-push factor.

The other factor – overheating of economy – is not the cause of inflation in India. Overheating refers to a situation when the industrial sector has exhausted its capacity to produce, but there is still a demand, leading to price rise.

The Indian economy is clear not overheating, he said. The investment rate in the economy exceeds 36 per cent.

With an ‘incremental capital-output ratio' (or ICOR, which measures how many additional units of investments you need to get one additional unit of output) of 4:1, “we should be able to grow comfortably at 9 per cent.”

Dr Rangarajan stressed that the ICOR in India is high, meaning more investments are needed for additional output. If the ratio could be brought down (by productivity increases), the economy could grow at 10 per cent, he said.

He said that even if the inflation is due to shortage of foods, there has to be a monetary policy response. This is because while inflation may have its origin in food shortage, it leads to rise in prices of non-food items too. Monetary policy measures, such as raising interest rates, are therefore needed to check demand growth, Dr Rangarajan, a former RBI Governor, said.

Inflation vs growth

While there may an inflation vs growth debate in the short term, in the long run, they converge.

“Several studies have established that in the long run there is no trade off between the two,” he said, adding that “growth rates become increasingly negative at higher rates of inflation.”

“We must remain committed to maintaining inflation at a low level,” he said.

But this leads us to what the appropriate level of inflation is. Determining the “threshold inflation”, or the point at which it begins to hurt growth, and targeting that level of inflation are complex subjects with problems of their own.

In his opinion, “inflation rate of around 5-6 per cent may be acceptable.”

Dr Rangarajan said he was in favour of “soft inflation targeting,” or striving to achieving a targeted inflation rate but without being too fixated about the target.

He said that he expects inflation to come down to 7.5 per cent by the end of this month, but one needs to see how global crude oil prices move.

As for next year, “we should be happy if we are able to bring down inflation to 6 per cent.”

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