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Can rate hikes prevent oil and MSP driven inflation?

The Reserve Bank of India had increased the policy interest rate by a quarter of a percentage point to 6.25 per cent in June.

business Updated: Aug 02, 2018 11:09 IST
Roshan Kishore
Roshan Kishore
Hindustan Times, New Delhi
monetary policy review,monetary policy review by rbi,repo rate current
The Reserve Bank of India (RBI) seal is pictured on a gate outside the RBI headquarters in Mumbai.(Reuters File Photo)

The Reserve Bank of India’s monetary policy committee (MPC) hiked the policy rate by 25 basis points on Wednesday to 6.5%, the highest in two years.

One basis point is one hundredth of a percentage point.

The decision was in line with most polls. The MPC’s statement says that the June round of RBI’s survey of households reported a further increase of 20 basis points in inflation expectations for both three-month- and one-year-ahead horizons compared with the last round. These values have increased significantly in the last one year. Put simply, this means most people expect inflation to rise.

The question which needs to be asked is whether an interest rate hike at the present juncture can help contain inflation? A short digression on the conceptual basis of inflation targeting is useful here. The argument that an interest rate hike controls inflation assumes higher rates increase the cost of capital and hence prevent an economy’s actual output from overshooting its potential output. Actual output exceeding potential output is thought to be inflationary because it creates excess demand for scarce resources at a given point of time.

The MPC statement lists five factors which will shape the inflation outlook: a larger-than-average increase in minimum support prices (MSPs) and a good monsoon affecting both food and normal inflation, crude oil prices continuing at elevated levels, a softening of inflation due to the government’s decision to cut the Goods and Services Tax (GST) on several products and services, and the pass-through of rising input costs and improving demand conditions on general inflation.

There is no way in which high interest rates can counter tailwinds to inflation from rising oil prices and increasing MSPs. Both fuel and cereals have no close substitutes. This makes their demand largely price-inelastic. This implies that consumers do not change the quantity they consume even if prices go up or down. Because India is dependent on oil imports for meeting its energy needs, there is little it can do to contain inflation when international oil prices rise.

A comparison of the Consumer Price Index and Brent crude prices shows that there is a clear relation between the two.

The preceding discussion suggests that even a hike in interest rates in unlikely to contain inflation at the present juncture. Higher interest rates have an opportunity cost for both the private sector and the government. They increase the cost of doing business, especially for small enterprises which mostly rely on bank loans for their capital requirements. Higher rates are also likely to increase yields on government bonds, which will lead to an increase in interest payments on government borrowings. This can upset fiscal calculations.

To be sure, there is little anybody can do to influence RBI’s decision, given the autonomy it enjoys under the present monetary policy framework.

Perhaps it is time to revisit the conceptual basis of inflation targeting in India, so that such decisions can be questioned without the government violating the autonomy of India’s central bank.

First Published: Aug 01, 2018 14:37 IST