Unravelling India’s Inflation Puzzle

From 2003, the Indian economy enjoyed a boom in growth coupled with moderate inflation for five years. The economy grew at a rate close to 9 percent per year, until it was punctured by the global financial crisis of 2008. Since then, the persistence of inflation in an environment of falling economic growth has come out as a “puzzle” to policymakers’ and many in the financial market. Why has the current slowdown in growth not been disinflationary? This paper contends that there were two important policy errors that are behind the stagflationary outcome. The rapid deterioration in public finances in response to the global economic crisis while stimulating demand temporarily managed to pull down the potential growth rate of the economy. The RBI compounded the problem by being sluggish and soft on inflation after the economy bounced back from the effects of the global economic crisis because it systematically overestimated the potential growth rate of the economy. This meant that by the time monetary policy was tightened, high inflation and inflation expectations had already become entrenched. That is why the current growth slowdown has not been disinflationary