HOW LOW INFLATION CAN RESHAPE INDIA

India's inflation may be undergoing a structural shift, supported by the RBI's flexible inflation-targeting policy. This lower, more stable inflation could have larger macroeconomic implications, but can it sustain?

- BY DEEPA VASUDEVAN

Nearly a decade ago, India's central bank adopted a framework of "flexible inflation targeting", or FIT. It is widely accepted that inflation has been managed well under this mechanism.

Chief economic adviser V. Anantha Nageswaran recently pointed to the remarkable decline in inflation in recent months and suggested that India may even be witnessing a structural transformation in inflation.

Certainly, inflation data for this year support this idea. The retail inflation rate has dropped from 4.3% in January to 0.29% in October; wholesale inflation is down from 2.3% to (-)1.21%.

For an inflation-prone country like India, low inflation for a sustained period is an achievement in itself, and the Reserve Bank of India (RBI) has rightly been lauded for its deft management of the situation.

But if, indeed, the Indian economy is moving towards structurally lower inflation, there are some other macroeconomic variables that could face a significant impact as a result.

INFLATION-RUPEE LINK

The key impact, as Nageswaran noted in his speech, will be on the rupee's exchange rate. On a day-to-day basis, the rupeedollar exchange rate fluctuates in response to actual and expected dollar flows. But in the long run, exchange rate depreciation tends to be related to inflation differences between economies, as per the theory of purchasing power parity.

The inflation differential between the US and India has fallen significantly since the RBI adopted inflation targeting in June 2016. The average gap in the FIT era is about 1.6%, a big drop from the 6%-plus gaps in the years preceding it.