CENTRAL BANK CONUNDRUM

Whenever there is a hike in the interest rate, the economist is apprehensive about its impact on growth. The recent rate hike by RBI also poses the same apprehensions among the economists that these decisions could be growth restrictive as the economy has not revived completely.

If we look at the inflation rate, it was seeing a continuous surge from October, and the recent data of May shows that it has reached 8.6% highest since 1981. This exponential increase in the inflation rate is attributed to the rise in food inflation. Various economists suggest that the R.B.I rate hike will not be able to tame this inflation because of the international phenomenon. Instead, it will hurt the growth prospects.

If we look at the data more carefully, we will find that a fast-forwarded rate hike was unavoidable because of five primary reasons- (Joshi, 2022)

1. Broad-based inflation- The recent inflation is not just the result of the international phenomenon; various factors have made it long-lasting and broad-based. It’s not just our headline inflation (which includes food and fuel) surging. Our core inflation, too, is hovering around 6.8%. Every commodity in RBI’s basket shows an increase in prices, making inflation broad-based.
2. Constitutional obligation- Monetary policy committee is constitutionally obligated to keep the interest rate at 4% (+/- 2%); if we look at the graph since January, it has been above the allowed limit, and even the recent R.B.I inflation expectation is showing that it will be 6.7% which means that this fiscal year inflation will be above the allowed threshold. R.B.I. has to give the government reasons for the same as the Monetary policy committee’s primary responsibility is to control inflation.
3. Negative Real Policy Rate- Our repo rate is still below the pre-pandemic level. If we see our real policy rate, i.e. interest rate minus inflation, we will find that it is negative, which means that the value of money deposited in our bank is getting eroded in real terms; this will have a direct impact on savings pattern.
4. Higher inflation expectation- The recent RBI inflation expectation survey and IIM Ahmedabad inflation expectation survey show that people feel that inflation will also remain high for the upcoming period. The different studies suggest that higher inflation expectations hurt household expenditure patterns; Juster and Wachter, in 1972, did the research and established that higher inflation expectations result in lower spending on durable goods. (Shankar, 2015)
5. Increase in interest rate by Federal reserve- With the increase in federal fund rate, India has seen a massive outflow of capital; till the 10th of June, 25 billion dollars had been withdrawn by the foreign portfolio investors. The Fed is expected to increase its fund rate further; hence, RBI must increase its repo rate to tackle the impact.

Though the rate hike was unavoidable, that doesn’t mean we can negate the impact it will create on consumption patterns and demand in the economy. But the normal forecast of monsoon and increase in consumer confidence, as reflected in the RBI survey, does give the cushion to MPC to decide on a rate hike. Also, the allowance of credit cards to be linked to UPI will push the consumption of small, durable goods like laptops, smartphones and other small-ticket items. The risk that this unanchored inflation poses to macroeconomic stability is enormous, and the central bank must be ready to answer these complications.

Joshi, D. (2022, June Friday). Google. Retrieved from Indian express: Dharmakirti Joshi writes: RBI leans harder to rein in inflation, but rebound in services will put upward pressure on prices

Shankar, S. Y. (2015). Inflation Expectations and Consumer spending in India; evidence from consumer confidence survey. Reserve bank of India occasional papers, 41-43.