The new world of 4% inflation
Business Standard, 11 March 2019
From 2015 onwards, RBI has committed to delivering year-on-year CPI inflation of 4%. Most of the discussion on inflation targeting has emphasised how low and predictable inflation stabilises the macroeconomy. Expectations of stable 4% inflation change many things about how we plan for the future. In this article, we show implications for wage hikes, borrowing, public finance, rupee depreciation, corporate investment and fund management.
The new world of low inflation
A long inflation crisis began in February 2006. The policy community was persuaded that institutional reform of monetary policy was required, which led up to the Monetary Policy Framework Agreement (MPFA), signed on 20 February 2015. RBI has been transforming itself to deliver on the transparent single-objective of 4% inflation. So far, the points of pain have been inflation that is too low, not too high.
It now looks likely that RBI will succeed in delivering inflation in the region of 4% all the way out to 20 February 2020, thus giving a full five years of performance in macroeconomic stability. Before the MPFA, the thumb rule for inflation in the future was 8%, and now we have increasing confidence in stable 4% inflation. This has important consequences for numerous areas of decision making in the private sector and in public policy.
Impact on wage hikes
Our thumb rules about wage hikes change. Earlier, wage hikes were anchored around the number of 10%. The floor for wage hikes was 10%, which was 2% real, and some employees got more than 10%. Now we need to anchor ourselves around 5% wage hikes. Keeping up with inflation is a 5% wage hike, and some employees will go above 5%.
When inflation comes down, for some time, the economy keeps going with old assumptions about inflation. Perhaps hiring by firms has been slower than usual in recent years because wages have been too high compared with growth of the top line (that has declined because of lower inflation). Perhaps we will get back to a more normal environment on the labour market once firms recalibrate down to lower wage hikes.
Impact on borrowing
Lower inflation changes how we think about debt. High nominal growth has a way of making old loans subside. In India, we had got used to the assumption of 15% growth in the balance sheet every year. This gave a doubling every 4.6 years. So a loan which feels like a stretch today is half as worrisome within 4.6 years; both sides have to only fight it out for the first 4.6 years.
This was particularly important for banks and banking regulation. Banks were used to racking up bad debt and then growing out of it. Banks would lend 100, of which 20 went bad. Accounting and regulatory tools were used to postpone the bad news, so the bad debt was only confronted after 4.6 years. At this point there was a recovery of 5 and a loss of 15, but the loss of 15 was expressed on a total assets of 200, and that was survivable.
The old environment of sharp growth of the balance sheet has changed. When balance sheet growth drops to 11% a year, in the low inflation environment, this is a doubling every 6.3 years. Alongside this, the willingness to play the old game of hiding bad news has reduced at all levels: DFS, RBI, bond market and corporate boards. These two factors have induced a valuable sea change in the behaviour of the debt market. The lending process needs to become much more analytical, away from the old ways of doling out debt without studying the borrower.
Impact on public finance
The key number that drives the budget process is the assumption about future nominal GDP growth. Traditionally, big numbers went in -- 6% growth and 8% inflation was 14% nominal GDP growth. But now we should be more cautious: 6% growth and 4% inflation gives 10% nominal GDP growth.
Impact on INR depreciation
When Indian inflation was at 8% and the world was at 2%, this created a systematic pressure of about 4% rupee depreciation every year. With an inflation target of 4%, that systematic pressure is largely out of the way.
There will, of course, be substantial exchange rate volatility. When emerging markets float the exchange rate, they get to about 12% volatility. When India fully graduates to a modern monetary policy capability, we will get much higher INR volatility. But there will be no systematic pattern of INR depreciation.
Impact on rates of return
Assumptions about rates of return in India tend to be very high. We tend to look back at the BSE Sensex performance from 1979 to 1990, and the Nifty returns from 1990 onwards, and form a very optimistic sense of the rates of return on public equity. These returns assumptions need to change, because inflation has come down by 4 percentage points, and because the equity index got a one-time surge when India opened up.
If you used to believe that the long-run average Nifty returns will be 16%, you need to rescale this downwards to 12% owing to lower inflation. The rough numbers may be as follows. With an inflation target of 4%, the short-term riskless rate may be 6% on average. The equity premium may be 5 to 6 percentage points, giving equity index returns of about 11 to 12 per cent.
This impacts upon corporate finance, structuring of private equity funds, etc. The process of business building will be put on better foundations when we fully adapt the assumptions underlying financial analysis to the new low-inflation environment.
When inflation comes down, for some time, the economy keeps going with old assumptions about inflation. Perhaps investment by firms has been slower than usual in recent years because it has been hard to find projects that are viable at excessively high hurdle rates. Perhaps we will get back to a more normal environment in investment when we recalibrate to lower required rates of return.
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