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News: The Indian economy has been hit by inflationary shocks. The RBI failed to keep the inflation rate below the upper threshold of 6%. Only after inflation hit 7%, it raised the repo rate.
Mandate of the RBI
In 2016, an independent monetary policy committee was constituted. It embraced the idea of inflation-target.
The Reserve Bank of India is 4 per cent, with a band of 2 per cent on either side. However, the RBI did
Monetary authorities raise interest rates if inflation is above the preferred target, and vice versa. It causes a compression in demand (and a fall in economic activity), which in turn will reduce inflation.
What are the causes of inflation?
Some part of inflation is coming from abroad. For example, global supply chain disruption and so on.
There has also been a steady outflow of foreign funds from the stock market. This caused the rupee to depreciate. This raised the prices of imported goods, for example petroleum products. This further added to the inflationary woes.
Measures Taken So Far
The Monetary Policy Response
The RBI has raised the cost of borrowing by increasing the repo rate, with a promise of more to come.
The Fiscal Policy Response
The central government has cut fuel taxes. Further, it has also banned the export of certain items.
What are the problems in India’s inflation targeting framework?
In a bid to follow international best practices, the RBI seems to have fallen for a fashionable framework, without thinking about the structure of the Indian economy. This can be illustrated through the following points.
The first point relates to agriculture’s role in the Indian economy. India’s non-food and non-oil components of the consumer price index CPI are about 47%. The RBI has no control over international prices of food and oil. Therefore, it is left to squeeze less than 50% of the domestic economy to lower inflation.
The real interest rise works through demand compression. But the problem is on the supply side.
The RBI’s monetary policy is silent on the exchange rate and its effects on output in the Indian Economy.
– For example, Until the 1970s, the monetary policies aimed to achieve both, internal balance (full employment and low inflation using monetary and fiscal policies); and external balance (balanced current account through the exchange rate).
The inflation targeting can be at odds with the external balance. For example, as the RBI raises interest rates, outflows will possibly slow down with the rupee appreciating.
Over time, from a policy perspective, the internal balance has come to mean only low inflation, since “the market” will ensure full employment.
Further, the Reserve Bank of India policy targets demand constraints. It faces the problem of tackling Supply shocks (originating from food and oil, primarily). If output is stabilised using macroeconomic policies, it can lead to prices rise even at higher levels. Further, on the other hand, if the authorities try to stabilise prices, it will lead to a fall in the output and employment in the country.
What is the situation of India’s foreign exchange reserves since 2020?
Until 2020, India had seen massive portfolio capital inflows, and its current account deficits were financed by foreign reserves.
In about six months, the foreign exchange reserves have fallen from around $640 billion to around $600 billion due to reversal in portfolio inflows. The RBI has executed “sterilised intervention”, in which it has bought foreign exchange (with rupees) and sold the government bonds.
Source: The post is based on an article “The inflation tightrope” published in the Indian Express on 20th June 2022.