RBI fighting a losing battle

The Reserve Bank of India has raised its interest rates again this week in an effort to curb inflation that has seen double digit growth in recent months. This is another rate hike in the long series of rises started by the RBI in March 2010, yet inflation continues unabated. This is hardly surprising since the tool that the RBI has is a blunt instrument.u00a0The tool -- interest rates work to control inflation only if there is excess liquidity in the system that needs to be mopped up, lest it power the increase in prices.u00a0 In our case, the system is far more complex, and controlling just one aspect has not proved to be very effective -- in fact interest rates have risen so much that they are now an impediment to our much vaunted economic growth.


Taming inflation: Rising inflation eats into the nominal interest rate
(the stated rate), reducing its real effect on both borrowing and lending.

The forces that work on inflation are not just the supply (and demand) of money, which is what the Reserve Bank is trying to control by making it more expensive to borrow money. The supply and demand of real goods and services are equally more important determinants of the price levels. We, in India have had the good fortune of high economic growth with rising income levels, which has spurred demand, both for essentials and luxuries.

Our government is trying to build its version of a social security network via schemes like the NREGA among others. The resultant incomes are spent on food and other essentials while the supply of these has not kept pace. This will inevitably lead to inflationary pressures that the RBI's tools cannot do anything about. Much has been written about the supply constraints in the agricultural sector, in infrastructure -- all of which feed inflation and are beyond the purview of the RBI.

Systemic constraints remain too - much if India's money is not in the banking system at all. These markets do not even participate in the official monetaryu00a0 system, so any tweaks by the RBI have little or no impact. At the same time, there is little or no resistance to the rise in prices from the public.

Resistance does not always mean that people need to protest or form a mob, but does mean that they resist the higher prices by buying less, thus pressurising the suppliers to reduce their prices. The RBI's interest rate hike is not going to create this demand side pressure.u00a0u00a0

Sadly, inflation often goes into a self sustaining cycle, where rises in prices are linked to rises in incomes. This happens both in the government and in many parts of the unorganised sector. The higher incomes support purchases, which in turn raises prices.

With the rise in interest rates, the RBI hopes that we will save more, borrow and spend less so that the money sloshing around in the economy is contained. But in this too, it is thwarted -- for purchase decisions are based on expectations as much as current realities. Rising prices make people and businesses tend to hoard goods to save themselves from buying the same at higher prices later. This further restricts the supply of goods in the market -- pushing prices further up.

The incentive to save due to higher interest rates has to be countered by a matching assurance that prices will not continue to rise --which is not possible by tweaking rates and money supply alone. Rising inflation in fact eats into the nominal interest rate (the stated rate), reducing its real effect on both borrowing and lending. In a system where people begin to believe that inflation is likely to rise faster than interest rates, it is smarter to borrow than to save, for the real (inflation adjusted) value of what will be returned is less than the paper value.

Unless the RBI can be seen to be totally in control of this process, reining in inflation with measured rises in rates -- it has a tool that blunts itself by being used. This, it cannot do aloneu00a0 --without stamping down on the other causes of price rise, the Reserve Bank seems to be fighting a lone, losing battle.

Meeta Sengupta is a writer and researcher in education policy and international business