RBI needs a balancing act, and help

The Reserve Bank of India recently raised the policy interest rates by 0.5 per cent. This came on top of two rounds of interest rate increases, all together raising the rate 1.4 per cent between May and now. The RBI is not alone in doing so. The US Fed has already hiked its policy rate by an unprecedented 2.5 per cent since March. The Bank of England raised rates by 0.5 per cent a day before the RBI.

The task before the RBI is particularly difficult. Economic growth is slowing down; consumer price inflation continues to remain at an uncomfortably high level, hovering around 7 per cent, which is above the 2-6 per cent tolerance band of the RBI; the Rupee is falling against the US dollar (though slightly rising against the Euro and Yen), reaching the Rs 80 mark for the first time in history; interest rates are under strong upward pressure as all the major central banks of the world are withdrawing from ‘cheap money’ policy.

The government spokespersons would point out that these developments are not restricted to India and are global phenomena beyond the control of Indian policymakers. In the UK, consumer price inflation has jumped to 10.1 per cent, the highest since 1982. US inflation has gone above 9 per cent, again the highest in over 4 decades. And these are economies that had inflation rates below 2 per cent for a long time, despite pursuing exceptionally loose monetary policies for decades. Rising food and energy prices are the major drivers for this spurt in inflation all over the world.

Interestingly, amidst the global growth slowdown, India, according to the most recent IMF projections, is currently the fastest growing big economy (for 2022, India: 7.4 per cent, China: 3.3 per cent, US: 2.3 per cent, UK: 3.2 per cent, ASEAN-5: 5.3 per cent, World as a whole: 3.2 per cent). Even if tighter monetary policy reduces GDP growth by a couple of percentage points, India would still be growing at above 5 per cent. Nonetheless, the government knows that high inflation -- specially food and fuel inflation -- apart from causing hardships to common people, is also politically dangerous.

The basic problem for the RBI is that controlling inflation by standard monetary policy tightening would have unintended consequences. For one, raising interest rates, by making borrowing costlier, would cut back consumption (specially loan-financed spending on new houses and consumer durables) as well as private investment expenditure. Fall in aggregate spending would slow down the growth in GDP and employment. Further, rise in interest rates would raise the cost of financing government borrowing. This, in turn, would increase the cost of debt-servicing in the future and would further cut into development spending, specially spending on infrastructure that is crucial for sustaining high growth in the longer term when supply-side factors and capacity constraints, rather than deficiency of aggregate demand, become important.

If the RBI refrains from following an aggressive monetary policy when all the major central banks are going down the path of unprecedented bouts of interest rate hikes, more funds will flow out of India, putting further downward pressure on the Rupee and hiking the inflation rate further by raising the rupee-cost of imports. Containing the depreciation of the Rupee by selling foreign exchange by RBI cannot be carried out beyond a certain point. India’s foreign exchange reserves have come down from $642 billion in September 2021 to $572 billion in August 2022.

There is no hope of the inflation rate abating in the near future as Russia’s Ukraine war and the associated cutback in gas exports from Russia and the fall in supply of grains, edible oil and minerals from both the countries are showing no indication of ending soon. The continued disruption in production, especially in China (a major supplier of inputs for the global supply chains of many manufactured products all over the globe) as a result of Covid-induced lockdowns and energy shortage, together with a sharp rise in transportation costs, are contributing to the worsening inflation scenario.

Economists have no clear idea about when tightening of monetary policy to fight inflation would begin to hurt growth. Further, this trade-off between inflation and growth changes over time. Hence, policymakers basically follow a trial-and-error method here. But if inflation continues at a high level for a long time, it gets entrenched in the form of high inflationary expectations, leading to a wage-price spiral that becomes more difficult to control without bringing about a sharp recession. That is why the RBI cannot afford to remain passive, especially when the other major central banks are hiking rates. It is better to gradually press down the brakes than bring the economy to a grinding halt by a sharp jamming of brakes at a later point in time when there is no other option.

It is also important to remember that though there is a kind of trade-off between inflation and growth in the short run, there is no such trade-off in the longer run. Controlling inflation and bringing back price fiscal stability is essential for attracting investment and stimulating growth. Hence, over the long haul, inflation control is needed for sustaining growth.

Apart from monetary policy tightening, which runs the risk of causing a recession, controlling inflation requires help from the fiscal and trade authorities, too. This is particularly so when the basic cause of inflation is coming from the supply side (rather than a rise in demand) in the form of rising prices of food, energy and other essential inputs. Here, reducing the indirect taxes on these products (specially food, fuel, fertiliser) and, in some cases, increasing subsidies, help to reduce prices and bring down the rate of inflation.

In the case of supply side or cost-push inflation, monetary policy tightening alone will cut aggregate demand and growth but may not succeed in bringing down inflation significantly. However, cutting indirect taxes and raising subsidies would worsen the fiscal deficit and would contribute to general inflation. Hence, raising direct taxes, especially on the rich, would be needed to maintain fiscal stability. Reducing import duties (to encourage more imports) and raising export duties (to reduce exports) would also increase domestic availability of goods and help reduce prices.

Thus, the RBI alone cannot be responsible for bringing down the continuing high inflation.

(The writer is a former Professor of Economics, IIM, Calcutta, and Cornell University, USA)