Inflation - An assessment of the RBI’s actions

Background:

The WPI Inflation was at 3.22% at the start of October 2007 which was well within the range of 4-5% that the RBI wanted to maintain. However, there was a growth in the broad money (M3) by 22.4% year-on-year. The RBI had started increasing the CRR rate in order to absorb the keep the M3 growth at levels that was acceptable for them (17-18%). From December 2006 till October 2007, the RBI had already increased the CRR by a total of 150 basis points from 5% to 6.5%

October 2007 – October 2008:

This was a period when the economy was growing really well and the mood among businesses was upbeat. From the quarterly RBI reports, we see that their analysis was that there was an excess of liquidity in the system. They felt that this could lead to higher prices because of too much money chasing the limited goods thereby leading to an increase in the inflationary pressures. Since inflation was well within control, the RBI decided to go in for a control on the money supply by hiking the CRR.

Within the span of the period from October 2007 to October 2008, the RBI increased the CRR 7 times (from 7% to 9%) and the repo rate 3 times (from 7.75% to 9%). This led to a hardening of interest rates within the country. On the other hand, during the same period, the US federal funds rate had been brought down in order to deal with the start of the sub-prime crisis (from 4.5% to 1%). The increasing differential in the interest rates could have led to additional funds coming into India. So, in net effect, the hikes in the CRR did not have the desired impact of reducing the growth in M3.

The WPI however had started moving upwards. On analysing the various components within the WPI, we find that a significant portion of the increase is due to the following 2 components:

1.      Food Articles: This increased from 2.78% to 10.08% in the period under consideration. This was attributed by the RBI to increased demand domestically, higher global prices and supply-side constraints.

2.      Fuel, Power, Light and Lubricants: This zoomed from -1.79% to a peak of 17.99% during the 1 year. There was a very steep increase in the crude prices globally which was passed through to a significant extent to the customer by the oil companies.

We notice that the factors contributing towards these 2 components are more external than internal. Hence, they would be more difficult to influence via the monetary policy itself. In the end, we had prices rising up along with an increase in the money supply. The policy measures that were designed to curb money supply actually did not have its desired effect but led to cost-push inflation during this period. Thus, there was a cascading effect of the CRR hike on the WPI inflation and M3.

Moreover, this increase in CRR had also caused a tightening of interest rates. This, along with other global factors, contributed to a downturn in business sentiment which is evidenced by a reduction in the RBI’s Business Expectation Index by about 4.4%. This resulted in corporates opting for lesser loans.

Thus, the measures adopted could have potentially led to a situation of stagflation where costs were rising and unemployment was also rising. In the second half of October 2008, RBI shifted its monetary policy drastically in response to worsening international financial crisis by reducing the CRR by 250 basis points and the repo rate by 100 basis points. This is probably the stance that should have been adopted all along.  

What could have been done differently?

1.      In October 2007, the economy was growing and the inflation was also under control. The RBI could have let the interest rates remain low. This would have increased investment and in the long-term help create assets that could reduce supply side constraints. This would also have led to an increase in the inflation but it could also have put India on to a higher growth trajectory.

2.      In a span of 12 months, RBI had made 7 increases to the CRR and 3 to the repo rate. Generally, it takes time for the effect of the rate hike to be realized. By continuously increasing the rates in quick succession, it seems like the RBI did not give adequate time for its measures to sink in before making the next steps.

3.      RBI’s policy of tightening liquidity was counter to the stand taken by the developed economies. This may have led to a flow of funds from the developed economies into India. Rather than taking an approach that was opposite to that taken by the rest of the economies, RBI could also have continued in the same path. Globally, the liquidity position was anyhow starting to tighten. So, the RBI did not need to hike the CRR. This gives rise to a feeling that the measures taken by the RBI were more reactive in nature as opposed to reading the conditions and taking a call based on that.

4.      The parameters that caused inflation to spike were things that could be controlled better from a fiscal perspective rather than through the monetary policy. For instance, the government could probably have reduced excise duties to make crude import cheaper. Given the high prices of crude that prevailed at that time and that the oil companies were not in a financial position to bear more losses, it is difficult to check inflation through monetary policy alone.