From UPSC perspective, the following things are important :
Prelims level : Real interest rate
Mains level : Paper 3- Challenge of managing inflationary pressure
The article discusses the challenges in managing the inflationary pressure while ensuring the low interest rates and sufficient liquidity in the covid battered economy.
Growing inflationary pressure
- As the second wave eases, producers could pass on more cost increases to consumers, pushing up inflation.
- Inflationary pressures are on the rise, globally and domestically.
- Real rates in India have moved into the negative terrain and some measures of inflation expectations have begun to rise gently.
- WPI inflation was subdued last year during the first wave of the pandemic due to falling global commodity prices.
- This year is different, as inflationary pressures have surfaced in the WPI.
- And within WPI inflation, input prices are rising much faster than WPI output prices.
- Producers do not seem to be passing on much of the rise in raw material costs to output prices, perhaps worried that already uncertain demand could weaken further.
- After states roll back local lockdowns, the demand for goods and services will gradually picks up, producers may feel more confident about passing on raw material cost increases to output prices, pushing core inflation higher, particularly in the second half of FY22.
RBI’s role: Dealing with impossible trinity?
- Last year, RBI was faced with conflicting objectives on inflation, bond yields and the rupee, also known as the impossible trinity.
- It bought dollars to prevent the rupee from strengthening too much and purchased government bonds to keep bond yields from spiralling out of control.
- But this created excess rupee liquidity in the banking system, which over time can stoke inflation and other financial imbalances.
- These conflicting objectives are also likely to linger this year, and RBI will have to juggle them carefully.
- As the year progresses, space could open up for RBI to gradually shift the focus to inflation control.
- With the current account moving into deficit, the balance of payments surplus is likely to fall, so RBI may not have to purchase as many dollars as last year.
- The will result in decrease in domestic liquidity and ultimately an important part of the normalization of monetary policy and inflation control.
- RBI would still need to buy government bonds to support the administration’s borrowing programme.
- However, a large carry-over of cash balances could act as a buffer—they totalled ₹2.5 trillion at the end of FY21, almost double the recent average.
- This could help fund some of the unbudgeted rise in the fiscal deficit.
Way forward on controlling inflation
- If the need to buy dollars is lower than last year, RBI could gradually shift the focus to controlling inflation.
- Starting in 4Q 2021, when the proportion of the population vaccinated will hopefully reach critical mass, RBI need to start reducing the level of surplus liquidity, raise the reverse repo rate, and change its monetary stance to neutral.
- The aim should be to gradually push up short-end rates towards 4%, so that real rates don’t remain hugely negative for too long.
- An increase in the benchmark repo rate— currently 4%— can wait, perhaps until there are surer signs that the private investment cycle is rising.
Dealing with the three elements of impossible trinity this time is not as difficult for the RBI as it was last year, it needs to shift focus to inflation control at the opportune moment.
Back2Basics: Real interest rate
- A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
- The real interest rate of an investment is calculated as the difference between the nominal interest rate and the inflation rate.
Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)
The impossible trinity
- A theory that states that, in the long-run, a central bank that hopes to conduct independent monetary policy must choose between maintaining a fixed foreign exchange rate and allowing the free movement of capital.
- For instance, a central bank that chooses to increase the total money supply by adopting loose monetary policy cannot hope to maintain the foreign exchange value of its currency unless it resorts to restricting the sale of domestic currency in the currency market.
- The idea is derived from the academic works of Canadian economist Robert Mundell and British economist Marcus Fleming.