Combating inflation

The Reserve Bank of India’s (RBI) decision to raise the cash reserve ratio (CRR) by 75 basis points in its third quarter review of the monetary policy did not come as a surprise. It was widely expected that in view of the rising inflation the RBI will take measures to contain liquidity. By raising CRR, Rs 36,000 crore worth of funds will be sucked out of the system and banks will have so much less money to lend. By raising CRR, the RBI has signaled that it wants to mop up excess liquidity. Theoretically, the liquidity tightening exercise should also lead to increase in interest rates and curb inflation but in realty it may not have much of an impact. Since the Indian banking system is flush with funds and there are not many credit-worthy takers of big loans, lending interest rates are unlikely to go up due to the CRR hike. Besides, the soft interest rates regime has enabled many blue chip corporates to raise money on their own by issuing bonds.

The main reason for RBI raising the CRR is its concern about inflation. It had earlier said that inflation management was one of its top priorities. The food inflation has reached an alarming 20 per cent in recent months and the wholesale price index is again rising after remaining dormant for several months. It is expected that by March this year WPI may touch 6 to 7 per cent. It is also true that wholesale inflation is ‘artificially suppressed’ in India because the government did not allow the prices of petroleum products to be revised in line with the increase in international prices of crude oil.

But curbing liquidity may not help much in bringing down the rate of inflation because the primary reason behind price rise is the shortage of food stuff. As the supplies of vegetables, fruits, pulses, cereals, edible oil and sugar — the major contributors to food inflation — are far lower than demand, their prices will continue to remain high. Tackling inflation effectively needs long-term planning. To control prices of agricultural commodities, for example, the country needs to improve yield and manage input prices. But this can happen only through improvement in irrigation, using high-yielding variety seeds and land reform. Similarly, if steel or cement prices are to remain within a limit, the capacity and production of both have to go up.