The Reserve Bank of India (RBI) has cracked down on inflationary expectations on Tuesday, by hiking the cash reserve ratio (CRR) for the second time in two months. By doing so it seems to have got its way in the battle against inflation. The CRR hike will push up interest rates, cool demand, and perhaps slow down the economy. The finance ministry has been worried about the third possibility—and tried to talk the central bank out of an interest rate hike.
There is another area of contention between the two masters of our economic universe—exchange rates. Once again, the big catalyst is inflation. The finance ministry wants the rupee to appreciate so that imports get cheaper and inflation can be controlled. The central bank has been buying dollars with a vengeance to prevent the rupee from appreciating. It fears that a rising rupee would be a further invitation to volatile capital flows. Should the central bank worry about price stability or about financial stability at this juncture?
Inflation has reared its head after two years. Last week, the inflation rate, based on the wholesale price index, climbed to 6.58%—well above RBI’s professed safety zone of 6%. Prices of pulses and vegetables (including onions) have begun to touch dizzying heights. A perusal of price indices for agricultural workers show that in some states such as Punjab and Uttar Pradesh, the inflation rate is in double digits.
Since prices increase because demand exceeds supply, theoretically, the solution is simple: either increase supply or curtail demand. That’s easier said than done. The government has, in recent weeks, cut import duties on a range of commodities as part of its strategy to boost domestic supplies through cheaper goods from abroad. This has had no salutary effect—the inflation rate has gone up further. Unable to make any headway on the supply side, attention is now shifting to the demand side.
But that is now a source of conflict: between the government and RBI. While the central bank would prefer to slow down the growth trajectory by raising interest rates, the government would have none of it. There is a section within government, led by the finance ministry and supported by industry, which is arguing that any move to control demand through a hike in interest rates would signal an end to the current growth momentum. They hark back to 1997, when, in similar circumstances, RBI had raised interest rates and sent the economy into a tailspin. RBI, on the other hand, argues that the circumstances today are entirely different. Not only is inflation a global problem, worse still, there is a global shortage of essential commodities such as pulses and cereals.
And now, the finance ministry has reportedly introduced a new element to the debate by reportedly calling for an appreciation in the rupee. The logic here is that it would reduce the rupee value of India’s imports. RBI, rightly, has so far resisted this line of action and has continued to mop up dollars.
Why? The RBI is not telling, but Asian central banks, including RBI, are finding that their economies are awash with foreign capital. A lot of this is hot money that can suddenly change direction and harm the economy. Regional central banks fear that a rising currency would be an invitation to hedge funds and other purveyors of hot money, who see rising currencies as a one-way bet. Domestic money supply, too, can rise to dangerous levels if unstable foreign capital keeps pouring in. The concern of central banks in this part of the world are very real.
Clearly, political pressures will dictate an immediate policy response. But the issue is whether the ruling political establishment would like to ruin the party and instead learn to live with lower growth levels, but more moderate inflation. In either case, it is wrong to let political lobbying influence economic decisions. While in the real world, some external influences cannot be wished away, the fact of the matter is that we have a central bank with a proven track record.
So, let RBI decide.
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