The Problem with Low Inflation

Context

• Inflation Data:
  • CPI (Consumer Price Index) inflation: 2.07% in August 2025.
  • WPI (Wholesale Price Index) inflation: 0.52% in August 2025 compared to August 2024.
• Nominal vs Real GDP:
  • Real GDP: Adjusted for inflation; measures physical growth of goods/services.
  • Nominal GDP: Unadjusted for inflation; reflects monetary value of all goods/services and is critical for government’s fiscal calculations (tax revenue, deficit, debt).
• Budget Assumptions:
  • 2025-26 Union Budget assumed nominal GDP growth of 11% (₹357 lakh crore) from revised ₹321 lakh crore in 2024-25.
  • Fiscal deficit target: 4.4% of nominal GDP; Debt-to-GDP: 56.1%.

Relevance:

• GS3 (Economy / Fiscal Policy): Nominal vs real GDP, budget assumptions, inflation impact on tax revenue and deficit.
• GS3 (Monetary Policy): RBI’s role, price stability, corporate profitability, demand-supply dynamics.

Overview

Low Inflation: Implications

• Positive for consumers:
  • Prices of goods and services are rising slowly → higher purchasing power.
  • Reduces cost-of-living pressures for households.
• Challenges for government:
  • Slower nominal GDP growth → lower than expected tax revenue.
  • Makes fiscal targets (deficit, debt ratio) harder to achieve without additional revenue or expenditure cuts.

Nominal GDP Growth and Budget Arithmetic

• Current Trends:
  • Real GDP growth Q1 FY26: 7.8% (5-quarter high).
  • Nominal GDP growth Q1 FY26: 8.8% (3-quarter low) → below 11% Budget assumption.
• Significance:
  • Government projections for tax revenue are tied to nominal GDP growth.
  • Weak price growth reduces the monetary value of output, affecting revenue calculations.
  • Even with strong real growth, low inflation can depress nominal GDP.

Historical Perspective & Base Effect

• Nominal GDP regularly misses Budget targets:
  • Last 13 years: only 4 years matched Budget assumptions.
  • Economic forecasting is inherently uncertain.
• Base effect in FY25:
  • GDP revised from ₹321 lakh crore → ₹331 lakh crore.
  • Required nominal growth for FY26 to meet Budget: ~8% (lower than initial 11%).
  • Highlights dependency of fiscal arithmetic on nominal GDP benchmarks.

Causes of Low Inflation

• Oversupply / Weak demand:
  • Ideal scenario → low inflation is benign.
• Corporate profitability:
  • April-June 2025: sales rose ~5.3-5.5%, net profits increased 17-27%.
  • Indicates profits rising faster than sales → not due to productivity gains.
• Other factors:
  • Global commodity price moderation.
  • Weak investment (capex) → less demand pressure in economy.

Consequences for Fiscal Policy

• Short-term impacts:
  • Slower nominal growth → tax revenue below projections.
  • Pressure on government to maintain deficit and debt targets.
• Medium-term considerations:
  • If low inflation persists, may limit government’s capacity for new spending or stimulus.
  • RBI may maintain accommodative monetary policy to support nominal GDP growth.

Broader Economic Implications

• Policy tension:
  • Low inflation benefits consumers but can constrain fiscal space.
  • Balancing growth stimulus vs fiscal discipline becomes challenging.
• Market signals:
  • Strong corporate profits with weak sales growth → uneven economic expansion.
  • Potential signs of demand-side weakness despite supply-side stability.