The Reserve Bank of India (RBI) has done well to increase one of its key policy rates on Wednesday. It needs to do more in the new policy it is slated to announce at the end of July.
Central banks respond to higher inflation by making it more expensive for people and companies to borrow money. That restricts demand and helps cool down the economy.
Illustration: Jayachandran / Mint
Data shows that RBI has been slow to react to the threat posed by rising prices. Inflation rate has shot up, from 4.3% in the first week of January to 8.24% in the third week of May. And it is likely to go closer to double digits as the effects of the oil price hike ripple through the Indian economy and the provisional figures are updated.
Interest rates have barely budged over the same period. The yield on 10-year government bonds traded in the money market has inched up over the past six months, from 7.76% to 8.26%. So, interest rates have not moved much even as inflation has doubled. The result: real interest rates are now negative. This is one sign that RBI continues to run a very loose monetary policy.
Such low interest rates pose two problems. First, they will fan the fires under an overheated economy with growing fiscal and trade deficits. Two, they penalize savers and reward borrowers. Neither is good policy.
India’s central bank is likely to follow its Asian peers and keep pushing up the cost of money. This will be a high-wire act. Higher interest rates could engineer a modest slowdown. But they should not be raised to an extent where projects become unviable and companies pull back their investment plans. That is what happened in the mid-1990s. A repeat should be avoided, though that’s easier said than done.
The entire burden of inflation-busting should not be dumped on the central bank. The government, too, needs to do its bit, not by imposing price controls but by slashing the budget deficit. The total fiscal deficit is now approaching levels not seen since the crisis of 1991. Such an expansionary fiscal policy is dangerous, given the current state of the economy.
It also hampers the efficacy of monetary policy.
Sustained price pressures will feed inflation expectations, and perhaps lead to demands for higher wages from workers and price hikes by companies. If this spiral is to be avoided, the finance minister and the central bank need to move in tandem.
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