Every central banker is charged with the responsibility of keeping prices stable, but none has ever succeeded in doing that over a long time. For, the economy has the incorrigible habit of going into inflation and recession alternatively and the central bankers have to manipulate the interest rate to bring the economy back to stable growth.
What level of inflation should be tolerated is a question that has different answers. But almost everyone agrees that some inflation is desirable to no inflation at all, because at zero inflation there is the danger that the economy may lapse into recession. Japan discovered this at great cost. Most developed countries seem to agree that inflation beyond 2 per cent should be a matter of concern. The RBI has been more liberal and inflation even at 5 is tolerated without calling for positive action.
It is when inflation crosses the tolerance limit that the central bankers are confronted with the real challenge. Inflation is equated with excess demand which is sought to be curbed by increasing the interest rate. The interest rate that is used is the rate at which commercial banks borrow from the central bank. That rate is a signal for rate changes by commercial banks and the financial market. But how much the central bank interest rate should increase to check inflation is an open question.
First, there is no exact inverse relationship between interest rate and inflation rate. Second, there is a time lag between an increase in interest rate and a decline in the rate of inflation. Both make the task of the central banker rather difficult and susceptible to subjective judgment. The one advantage to the central banker is that he can raise or lower the interest rate at any time unlike the tax rate by a finance minister.
In most developed countries, in normal conditions, the central bank interest rate is expected to be around 3 per cent. This rate is called the neutral rate of interest. Since there is no unique relation between interest rate and inflation rate the convention is to increase the rate by 0.25 per cent each time, possibly within an interval of 8 to 10 weeks until inflationary pressures are defused. Possibly the total increase may not be more than 3 per cent over and above the neutral rate. A reversal of interest rate has to begin at that point to prevent the economy from running into recession, the reduction being also 0.25 per cent each time.
With the RBI the rates should be higher because its inflation target is higher. The neutral rate of interest may be about 5 per cent and it may require the interest rate to touch 8 per cent before inflation is defused and a reversal of interest rate begins. The repo rate is already at 7.75 per cent and the RBI should at best take only one more chance to increase it to 8 per cent.