From UPSC perspective, the following things are important :
Prelims level : Impact of rate hike on inflation
Mains level : Paper 3- Effectiveness of monetary policy in dealing with the inflation
The Reserve Bank of India (RBI) last week raised both policy rates and cut back liquidity in a surprise inter-meeting decision. The forcefulness and urgency of the policy shift have been seen as a signal of the RBI’s renewed commitment to fighting inflation via aggressive monetary tightening in the coming months.
How do higher inflation rates slow inflation?
- It is true that a large swathe of the global economy is in the throes of runaway inflation and that in many of these economies tightening monetary and fiscal policies is the right response.
- Initial conditions: But initial conditions matter as do the specific drivers of inflation.
- There are typically three ways in which higher inflation rate slows inflation.
1] Lowering inflationary expectations
- Suppose one believes that because a central bank has not tightened enough, future inflation will be higher.
- In that case, the obvious response is to bring forward future consumption and investment to the present, thereby adding to demand and fueling current inflation further.
- So, in principle, the central bank by credibly committing to bringing down inflation through aggressive current actions can bring down expectations of future inflation.
- It won’t work in India: This is a very potent conduit of monetary transmission in developed markets, where there is a wide variety of inflation-hedging instruments, as well as in some emerging markets — Brazil, for instance —where inflation-indexation is widespread.
- However, there is little empirical evidence that this channel works in India, even weakly.
2] Exchange rate channel
- Higher interest rates attract foreign capital that appreciates the currency, lowering import prices and, in turn, inflation.
- Again, this is a powerful mechanism in Latin America and Central Europe, where bond flows — that are sensitive to interest rate differential —dominate capital movements and the import content of the consumer basket is large.
- Will it work in India? This is not the case in India and, in any event, for this to work it would require extreme rate hikes in the country, given the anticipated aggressive tightening by the US Fed.
3] Curbing credit growth
- Raising both the cost of borrowing as well as its availability (for example, by increasing the cash reserve ratio) reduces credit growth, lowering demand, GDP growth and, eventually, inflation.
- It works well in India: This is the credit transmission by which higher interest rates dampen inflation and it works well in India.
- How much of today’s price increase is credit-driven? Even a cursory glance at bank balance sheets would suggest that credit growth is just treading water.
- Having recovered from being negative in mid-2021, real credit growth is running just around 2 per cent.
Comparison with inflation-monetary policy dynamics of 2010-11
- Back then, real GDP growth was clocking over 10 per cent per quarter, nominal credit growth 20-25 per cent, and real credit growth over 10 per cent.
- Inflation was unambiguously driven by an overheated economy and fueled by runaway credit.
- In the event, the RBI assessed the drivers of inflation to be originating from the supply side — higher food and commodity prices — and moved at a glacial pace, such that even after 12 rate hikes inflation remained in double digits for much of that period.
- Faced with a potential US Fed tightening in 2013, India found itself in a near-crisis situation.
- Today things are different. Much of the inflation is driven by global food and commodity prices.
- Despite the languishing private demand, core inflation remains high.
- But this has been the case for much of the last two years, strongly suggesting that the domestic supply chain disruptions in manufacturing and services, especially at the informal level, haven’t been repaired fully.
- The reason why firms locate in the informal sector in the first place is because of lower transaction costs, so when parts of the supply chain shift to the higher-cost formal sector, it shows up as inflation during the transition before increased scale of production and efficiency bring down the cost over time.
- None of these factors is affected much by higher lending rates.
- So the burden of taming inflation by tightening monetary policy will fall largely on lower credit.
- There is clearly a case to remove the extraordinary monetary support provided during the pandemic.
The RBI had misread the drivers of inflation badly in 2010-11. Hopefully, it won’t repeat that mistake this time.