Has RBI Policy to Contain Inflation Failed?

Subscribe to GoodReturns

Has RBI Policy to Contain Inflation Failed?
RBI came out with 2nd quarter review of monetary policy on 25-Oct-2011. This was much awaited policy review for investors in stock markets, bankers and economy in general. This came in the wake of latest inflation data which showed food inflation at 10.60 per cent ( Has gone up to 11.43 per cent on 27-Oct-2011). However the policy review was very disappointing. Barring de-regulation of interest rates on savings deposit, there was nothing new in the policy.

The inflation riddle which continues to baffle all of us was once again given the same medication by the regulator. The central bank increased repo and reverse repo rates by 25 basis points. This was 13th increase in repo and reverse repo rate since March 2010. We all know that all rate hikes have been done with an objective to contain inflation and stability to Indian economy. However, the fact remains that inflation concerns are far from over. Does this raise some questions on the RBI policy to contain inflation through monetary measures? Let us look at the hard facts.

In spite of multiple increase in repo and reverse repo rates, in the current financial year the WPI indicated rate of inflation has been 9.6%, which is abnormally high. Why it is that inflation has not been contained despite so many rate hikes. Though RBI has shown some optimism in the latest review and has indicated that the inflation may come down post December,2011, the view expressed by RBI shows that central banker is not sure about it . This gets manifested in the fact that RBI has shown serious causes of concern on inflation front.

The RBI in its second quarter review has stated that ,' Going forward, the inflation path will be shaped by both demand and supply factors.

First, it will depend on the extent of moderation in aggregate demand. Some signs of demand moderation are evident, although the impact is being felt more on the investment side.

Second, the behaviour of crude prices will be a crucial factor in shaping the outlook of domestic inflation in the near future. The benefit of a decline in global crude prices in the recent period has been more than offset by the depreciation of the rupee in nominal terms. Thus, the exchange rate will also have some impact on the behaviour of domestic petroleum prices.

Third, the inflation outlook will also depend on the supply response in respect of those commodities characterized by structural imbalances, particularly protein items.

Finally, there is still an element of suppressed inflation in the economy. Domestic prices of administered petroleum do not reflect the full pass-through of global commodity prices. Prices of coal and a few other commodities do not reflect the current market conditions. As and when price adjustments take place, they will add to inflationary pressures'.

These four points mentioned in the review document are clear cut indication that the inflation may or may not fall in the days to come. Let us look at these four critical points one by one. RBI has been successful in moderating demand in the economy but the fact remains that only investment demand has fallen. Increasing interest rates have resulted in high cost of capital and companies have reduced investments in new projects. This has also been reflected in the slowdown of growth. However, on supply side nothing substantially has changed.

Crude price is indeed a cause of concern. There has been consistent increase in the crude price and India has an economy felt the impact of increasing crude price on inflation. Recently when crude oil price started falling due to crisis in Europe, an expectation was built that crude price will fall in domestic market. However it did not happen as depreciation in rupee was so fast that entire benefit of fall in crude price was nullified by a depreciating rupee. Going ahead if global economy recovers, we may see further increase in crude price and this will derail inflation calculation once again.

RBI policy measures can do very little to remove structural imbalances which has been caused by supply side constraints and hence policy measures will not work on this front. It is indeed surprising that in spite of record food grains production of 241 million tonnes in 2010-11, we continue to have all time high food inflation. This shows the flaw in distribution chain and also inappropriate the government policy to contain food prices.

Can monetary policy measures do anything on this front? The answer is emphatic no. RBI is also worried about suppressed inflation as the effect of crude oil price has not been passed yet to the investors. As and when this is done, the inflation will increase further.

Then why is it that RBI has been increasing repo and reverse repo rates continuously. RBI has believed that by reducing money supply, demand for money can be reduced, which will pull down inflation. This is where effectiveness of monetary policy has always been questioned. RBI policy over a period of 18 months (since 2010) has been successful in slowing down growth but has failed to reduce inflation. Some analysts feel that increase in interest rates can only tone down growth in sectors which are interest rate sensitive such as auto and home loans.

Had the situation been worse off without RBI policy measures? Not really. Since inflation cannot be controlled by monetary policy alone, RBI has failed to control inflation by increase interest rates. RBI has put the entire economy into a vicious circle. Every time when there is an increase in inflation, RBI ups repo and reverse repo rates, but this does not work. If this vicious circle continues, then we will see interest rates been increased again and again but inflation will not be controlled.

While RBI was an extremely successful regulator in handling 2008 global crisis in terms of its impact on Indian economy, in the current scenario the regulator has failed. As a part of policy measures rate of growth has come down while inflation continues to be high. Isn’t it right time when the regulator should stop intervening through repo and reverse repo rate hikes?

It will be better if the government comes out with policy measures to control food inflation like working against hoarding, ensuring that foodgrains are not rotting in godowns and profiteering in not done by black marketers. Why should common man be made to suffer by paying higher rate of interest on loans, when the problem lies somewhere else.

InvestmentYogi

Please Wait while comments are loading...
Company Search
Enter the first few characters of the company's name or the NSE symbol or BSE code and click 'Go'

Thousands of Goodreturn readers receive our evening newsletter.
Have you subscribed?