India Ups Interest Rates, A Misguided Monetary Policy

In its June mid-quarter monetary policy reviews for 2011-2012, the Reserve Bank of India (RBI) increased two key interest rates; the repo rate (the rate at which the central bank lends money to banks) and the reverse repo rate (the rate at which the central bank borrows money) were increased to 6.75% and 5.75%, respectively. This shows that the apex monetary authority consciously decided to sacrifice rising economic growth in the interest of containing headline inflation, a decision supported by an article that appeared in the Economic Times last week.

I believe that these actions are short sighted and designed to appease those hurt by food inflation, without providing any lasting respite. The resulting contraction in economic growth due to a continued hawkish monetary policy by the RBI is an underestimated danger, and is too high a price to pay for a result that will be fleeting at best.

I certainly agree that food and essential commodity inflation is an increasing burden on India’s impoverished masses. Primary articles (including food) increased by an estimated 13% in 2010-2011, while non-food manufactured products inflation was at 8.5% in March 2011, well above its 4% medium-term average. As troubling as these numbers are, I do not think the RBI’s actions are going to provide significant relief. An important catalyst for inflation seems to have been overlooked in the article; the Finance Ministry has been deregulating gas prices in India for the last few years. As a result, the cost of one liter of petrol in New Delhi, for example, has increased from approximately $1 to $1.40 in the past three years. Increasing the price of such a key commodity has knock-on effects of inflation, effects that are unlikely to be stemmed by an interest rate hike.

Another possible cause of inflation that has not received much coverage is the relative performance of India’s economy versus that of the West, India’s major trading partner. With Europe’s increasingly worrisome sovereign debt crisis, and America’s continued unemployment issues and general low productivity (a policy argued against by Raghuram Rajan in this ‘Freakonomics’ blog), India’s robust economy promoted an optimism that has manifested a solid consumer spending (leading, the RBI fears, to inflation). A policy that seeks to reign in this growth risks jeopardizing India’s consumer-driven recovery from the recession, a recovery that may be key in returning global growth rates to normal.

Additionally, a cash subsidy program that is currently being instituted also promotes inflation. As long as the Finance Ministry maintains this policy of deregulation and cash injection, marginal interest rate hikes by the RBI are going to be powerless in arresting inflation. In other words, the ministry and the RBI seem to be clashing in their goals. In any case, most parts of India seem to have received a good, early monsoon this year that should help agricultural output. This in itself should provide some relief to the food inflation problem.

In conclusion, I do not think increasing interest rates can achieve the RBI’s goal of reducing inflation in the medium to long term, and I am not comfortable with the risk to GDP growth it entails. A better policy would be for the RBI and the Finance Ministry to work out how both their strategies can be executed, without impeding the other’s results. A possible solution may be a shift from using monetary policy to micro-manage inflation to adjusting fiscal policy in such a way that government spending is trimmed down and channeled into more productive avenues.

Photo CreditWikimedia Commons

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Aniruddha Barua

Aniruddha lives in Mumbai, India where he works for a real estate private equity fund. He graduated in 2009 with a Bachelor's degree in Economics from Grinnell College, IA. While at college, he studied everything from greek literature to religious studies to corporate finance. His interests include capital markets, international finance, monetary and fiscal policy, most sports and, occassionally, existential issues about pretty much anything.

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