Inflation, Interest Rates and Recent RBI Measures - Satarupa Bhattacharya

Many of you, who have been scanning the regular news now as you prepare for the imminent rounds of Group Discussions and Interviews at B-schools, would have certainly noticed that the increase in certain lending rates by the Central Bank have made headlines and raised concerns about how it is going to hit industry. In a release dated March 19, the Reserve Bank of India has raised the repo (repurchase) rate and the reverse repo rate by 25 basis points each to 5% and 3.5% respectively. This measure was taken primarily with a view to containing the alarming rates of inflation in the Indian economy.  But what actually is the repo rate? How does it influence inflation? And what does all this augur for Indian inflation in the current context? These are a few of the issues that we will try to simplify in this article.

Recent Inflation in India
Most of you probably know that inflation is a sustained increase in the price level of products. Let us say that a certain basket of goods cost Rs.100 in 2008. So for Re 1, you would have been able to buy 1/100 units of the goods. Now in 2009, if the same basket of goods cost Rs.110, then Re 1 would buy you only 1/110 units of goods. So the rise in prices by 10% also brought about a fall in the value of money. This is what a classic scenario of inflation entails.

Now, this inflation can be triggered by two different sets of scenarios:

One is where the aggregate demand for goods and services in the economy goes up sharply, either due to an increase in purchasing power of consumers, or increased government demand, or other factors such as relative price rises in countries with whom you trade. The rise in demand for goods and services pushes prices upward, creating what is called “demand-pull” inflation.

The other scenario is one of “cost push” inflation, where rising input prices (or changes in tax rates, supplier expectations and preference) mean that for the same price, suppliers will provide less in order to maintain their margins. This eventually leads to a fall in the aggregate supply of goods and services in the economy, driving up prices.

Inflation in India which has spiraled to alarming levels over the past few months can actually be viewed as a mix of the above factors. Firstly, thanks to the fiscal spending by the government to beat the economic crisis of 2008-early 2009, the Indian economy has been rapidly emerging from the blues leading to a rise in overall demand for goods and services. On the other hand, high commodity and energy prices combined with poor performance of the agricultural sector have exerted supply-side pressures, further fuelling the sustained rise in prices of goods.

The annual rate of inflation in India based on the wholesale price index rose to 9.89% in February, leading the Prime Minister to accede in Parliament that it was indeed a cause of concern. Food inflation, although it has cooled down from the close-to- 20% rates in December, continued to be a high 16.3% for the week ended March 6. The Central Bank has also been deeply worried as it appears that inflation will exceed the Bank’s baseline projection of 8.5% for end March. But in spite of that, most were predicting that the RBI would take any concrete measures only at the monetary policy statement scheduled for end April. The hikes in the rates announced on March 19, therefore, came as a sort of surprise.

Interest rates and inflation
By now, many of you would be wondering how or why the rates tweaked by the RBI will affect or contain inflation. And what are these rates? To understand that, we must first look at how changes in interest rates can affect inflation. We have mentioned above that increased amount of money in the hands of spenders raises the aggregate level of demand in the economy and thus prices, leading to inflation. Now, when interest rates are raised, loans become more expensive in terms of interest payments. Also, the incentive to save rises, rather than go for immediate consumption. This means that consumers want to spend less and industry too faces a crunch of loan funds for investment, implying a tightening of overall demand. Rising interest rates, in that sense, target the demand driven inflation in an economy.

The “repo rate” is the rate of interest that the RBI charges on its short term loans to Commercial Banks. Any increase in repo rate, thus, makes it more expensive for the commercial banks to borrow from the RBI and in turn, they have fewer liquid funds to lend to commercial or private borrowers. This drives up the general lending rate in the economy, impacting inflation in the manner described in the preceding paragraph.

“Reverse repo” is the interest which the RBI pays the commercial banks on their deposits with the former. Any increase in the reverse repo therefore makes it more attractive for banks to park their funds with the RBI. Thus banks could well consider keeping a part of their funds with the RBI rather than lend it out. A rise in the reverse repo could, therefore, potentially suck out excess loan funds from the system, once again meaning that spending in the economy is reined in, with the inevitable impact on inflation.

Will the recent rate hike be effective in controlling inflation?
Now that we have seen the rationale behind the revisions in repo and reverse repo, let us examine what analysts feel about the effectiveness of the RBI measures.

As you would have seen, a large part of the “transmission mechanism” through which repo/reverse repo movements affect inflation rests on the premise that banks will adjust their lending rates in response. Post the March 19 announcement by the RBI, banks have reacted cautiously. Most banking heads have opined that there is ample availability of liquid funds in the market and hence the repo adjustments may not lead to immediate hikes in lending rates. However, it does signal that funds are no longer going to remain cheap in the future and further rate-hikes are expected at the time of the monetary policy announcement in April. This message could lead to cautious spending and a leveling out of inflation.

Economists and analysts have also pointed out that with supply-side pressures on price levels being equally strong, if not more, rate adjustments can only have limited impact on price increases. Many industry heads also say that given the way inflation was spiraling, RBI’s reaction has actually been later than expected and hence markets may have already factored in the revisions which would create less of an impact.

More importantly, however, what this rate revision indicates is that the Indian economy is perceived to have firmly rebounded from the crisis and is well-poised on the path of growth. Since interest rate signals could constrict demand as explained in this article, the Central Bank had so far been very watchful and wary about changing rates. In a fragile or nascent recovery, even small curbs on spending could put the economy on the backfoot again. At the same time, crisis-driven measures are not sustainable forever, and can lead to hyperinflation when the economy starts to recover, as we have seen. A delicate balance is required which was very aptly conveyed by the RBI governor in his statement after the monetary policy review in January, where he spoke of the shift in focus from “managing the crisis to managing recovery.” Clearly however, the most recent data on industrial productivity and employment has dispelled doubts over the robustness of the Indian recovery, leading to these concrete signals of monetary tightening (through repo and reverse repo adjustments). The focus is now evidently on inflation, rather than recovery.