RBI's Monetary Policy: Not enough to control Inflation!

Published on Wednesday, December 04, 2013
The first question that comes to our mind is what is inflation, well it means a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. For Example, If price of potatoes rises to Rs 15/ KG from Rs 12/KG due to inflation, then it means the capacity to purchase potato decreases ( as consumers will have to pay more money for a KG of potato). 

Inflation affects the Economy in a big way. It affects both the poor’s as well as the affluent masses. When inflation affects an economy, to maintain the same level of living standards we would have to pay more. For Example: To enjoy the same level of potato i.e. 1 KG, consumers have to pay Rs. 15/- instead of Rs. 12/-. That is we would have to pay more for same amount of goods and services you had used prior to inflation. Our income may not increase at the same rate as inflation, which creates the problem.
At the time of inflation, financial planning becomes difficult. The reason being the value of money decreases with inflation. It would affect the pensioners more than the ones who are currently employed.

To combat the dreadful effects of inflation, government frequently uses to methods which are Monetary Policy and Fiscal Policy. Monetary Policy is the policy in which monetary authority of a country (Reserve Bank Of India for India) controls the supply of money. There are various tools which RBI uses under Monetary Policy.

Open Market Operation

At the time of inflation RBI sells the Govt bonds to people such that extra money can be pulled out of Economy and at the time of deflation RBI purchases Govt Bonds to insert money in Economy.

Reserve Ratio

Reserves can be of two types Cash Reserve Ratio (The Cash Reserve Ratio (CRR) refers to this liquid cash that banks have to maintain with the Reserve Bank of India (RBI) as a certain percentage of their demand and time liabilities. For example if the CRR is 10% then a bank with net demand and time deposits of Rs 1,00,000 will have to deposit Rs 10,000 with the RBI as liquid cash). The other one is Statutory Liquidity Ratio (It’s the percentage of  Demand and Time Maturities  that banks need to have in any or combination of the following forms 
i) Cash
ii) Gold valued at a price not exceeding the current market price,
iii) Unencumbered approved securities (G Secs or Gifts) valued at a price as specified by the RBI from time to time. 

The maximum limit of SLR is 40% and minimum limit of SLR is 24%. It’s 24% now).  Well at the time of inflation, RBI rises the Reserve Rates such that commercial banks needs to keep more amount with RBI, thus there loan giving capacity will reduce and the excess money from the economy can be churned out. During deflation, the rates are reduced to flush more money in economy.

Discount Rate

The rate at which commercial bank can borrow from RBI is known as discount rate. At the time of inflation RBI increases the discount rate such that the borrowing becomes costly and the excess money in the Economy can be slowed down and at the deflation RBI curtails the discount rate to put more money in Economy.

Fiscal Policy 

Fiscal Policy means a policy in which Govt adjusts its level of income and spending to control inflation. There are various tools of Fiscal Policy, such as

Tax Rates

During inflation, charges more tax to reduce the excess level of money in the economy and during deflation they reduces the tax burden.

Government Expenditure

Spending more for Economy means creating employment opportunities which will increase the money supply. For Example: Spending more on infrastructure will give job opportunities to many workers. Thus during inflation curtails expenditure and during deflation spends more and more.

Well, The inflation genie is out of the bottle and policy makers are busy taming it. The initial response  to high inflation had come from a plethora of fiscal measures (which are determined by the GOI) announced in early 2010 to control food price inflation. Monetary policy was on a much static, wait and watch mode at that point of time. Despite optimism that food price inflation would moderate quickly, it was quite still and only recently it started to fall appreciably as the monsoon and cropping outlook are improving. The opposite upward sloping curve for non-food inflation means that the onus of controlling has now shifted to monetary policy (which falls under the department of RBI, the central bank of our nation).
                                                    In theory, monetary policy can check cyclical demand size pressures. So before implementing large doses of monetary measures, we must be convinced that demand is the primary culpibable factor.
                                                  So the next issue, becomes the coveted journey from textbook to reality. The gigantic question that strikes our mind at this point of time is, - “How effective is monetary policy in controlling inflation, particularly in a country like India?”
                                                  To start with, I support RBI’s move to have a mid-quarter review of monetary policy. In a fast changing and quite unpredictable macroeconomic environemnt, there is a need for continuous assesment and policy action. By reviewing the monetary policy every six weeks, RBI can provide a more realistic and faster response to developemnts.
                                                     Coming now to inflation, if we look at the index, we see that inflation has been at double-digit level since Feb’2010. Latest figures show that in June’2010, inflation stood at 10.6%. The inflation in primary articles has remained at elevated levels for an extended period, with inflation crossing the 15% mark in recent months, the price rise phenomenon is now spreading to other segments aswell. Data also reveals that non-food manufacturing inflation has seen a rapid build up, rising from near zero in Nov’2009 to 7.3% in June’2010. This increase in price of manufactured goods is mainly due to the following factors: 1) Increase in prices of raw materials and industrial inputs.
2) Upward revision in wages and salaries, with several companies renegotiating their compensation contracts to match the higher cost of living (i.e. wage-price spiral).
3) The most important factor is the recovery in economic situation with some segments of industry now facing huge constraints to meet the constant rising demand.
                                                   Our Central Bank is understandably worried about this increasingly generalised nature of inflation. It has made its concern public and to bring down inflation, it has introduced a series of quick and successive policy rate hikes. Even Subir Gokarn, RBI’s deputy governor states that, “Inflation stays RBI’s prime focus”. The authenticity of his statement was rightly visible when on July 2,2010, the repo and reserve repo rates were hiked by 25 bps and further on July 27, 2010, RBI repeated the act, but this time, the reserve repo was hiked by 50 bps. The billion dollar question is whether these moves will help in cooling down price and bringing inflation back to the more acceptable 5% level.
                                                                                 The other problem that can be pin pointed at this point is whatever happens to manufacturing inflation alone doesnot determine the overall inflation situation in the economy. This is because we also have a more volatile component of primary articles inflation. And this doesnot respond to monetary policy alone. Controlling primary inflation, particularly food inflation, requires an altogether differnet strategy and unfortunately RBI has negligible role in that. Today, we are betting on a good monsoon that will give us a favourable output. And once the new crop comes into the market, food prices should settle down. However, this is not a solution to food inflation. We cannot keep chasing the monsoon every year to keep food prices under control. We have to realise that with high growth, rising incomes and aggressive development work being undertaken in rural areas, food demand is rising rapidly. And the only way to maintain price line here is to have a sustainable policy for the farm sector. In case of fruit and vegetables, we need to minimise the wastage ratio that can be as high as 40%. Here, government must encourage private sector participation in building the required storage and transportation infrastructure. Even with sufficient buffer stock of rice and wheat, the problem here lies with the failed public distribution system. We need to develop an alternate mechanism to Public Distribution System.  
                                                     By deploying monetary policy, we cannot hope to achieve medium or long term price stability. The right action to control inflation has to be in the form of acceleration of farm sector growth and ensuring comprehensive and timely distribution of agricultural produce. Also, focus must go back to economic reforms, which will ease supply-side constraints and bottlenecks. Monetary policy alone will never be able to tame inflation in a country like India where most of the inflation related factors lies beyond the scope of RBI. So its really a high time and we seriously need to ponder over this vital topic or else the genie will keep roaming around and soon we all will start dancing to its tune.
This article is written by Abhinav Saha. I am not responsible for his views and opinions.

About me

ramandeep singh

My name is Ramandeep Singh. I authored the Quantitative Aptitude Made Easy book. I have been providing online courses and free study material for RBI Grade B, NABARD Grade A, SEBI Grade A and Specialist Officer exams since 2013.

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