Inefficiency of the monetary policy

Inefficiency of the monetary policy

Why Increase in Repo and Reverse Repo Rates has not been Able to Tame Inflation?

Inflation is the biggest problem of India. Spiraling inflation close to double digits have taken economists, politicians, businessmen, policy makers & Mr. Dhruvi Subbarao aback. This may be pronounced as the toughest term for any RBI Governor who has to face constant criticism from almost every newspaper for constantly revising the key rates upwards. And on October 25, yet again it happened for 13^th time since March 2010. The spiral of inflation has caught the economy and RBI can’t do anything at the moment. Rising rates have affected the economy and growth has been compromised. With food inflation at 10.63% and general inflation being nearly 10% it’s a tough call for the policy makers.

There is a tradeoff between inflation and growth and RBI has chosen to favor policies to reduce inflation. The interests of the common have been kept at the top. With vegetables and other necessities reaching sky rocketing prices its becoming very difficult for a common man to earn an sustain with a minimal income level. Rupee value has eroded. Nominal income increase has not been enough to surpass the inflation levels. As a result, real income and purchasing powers have fallen drastically. There has been no addition in real money with the people. Here we would like to quote an example.

The interest on Fixed Deposits with banks is around 9% per annum. So if a person invests Rs. 1,00,000 today he will get Rs. 1,09,000 after one year if we assume no taxes. The inflation rate is around 10%. If the same person buys a good for Rs. 1,00,000 today he will need Rs. 1,10,000 the very next year to buy the same good. This clearly shows the eroding value of currency. Even the savings appreciation is not able to cope up with higher levels of inflation.

The rate hike has become so common since the past 1.5 years that now people don’t even pay attention to the earlier breaking news “RBI HIKES KEY RATES BY ____ BPS.” People already predict the moves and make their decisions. Businesses are finding It difficult to raise money, investments are going out of the country, people search for safe havens to park their savings but nothing at present is giving them respite from the inflation and rate hikes. 

The impact of increasing the repo and the reverse repo rate has not been uniform. Initially the inflation has decreased but after July 2010 the inflation rate in fluctuating irrespective of changes in interest rates. This shows that the favourite tool of the policy makers to tame inflation has indeed been unsuccessful.

Now let’s examine as to why the policy has been unsuccessful.

First of all I would like to tell about demand side inflation. This is the kind of inflation which is generated due to excess demand by the consumers. Since the supply is limited an increase in demand creates a situation of excess demand and puts upward pressure on the prices of goods & services which leads to inflation. It is this kind of inflation where oppressive/contractor policies like raising interest rates work because these directly affect the purchasing power by decreasing the easy accessibility of money. Developing countries are the min ones which experience demand side inflation. In India there has been increase in demand of goods and services but this reason is not sufficient to justify an inflation level of 10%. There are some other reasons which have created the actual problem.

First problem is the government expenditure. Inflation is caused when there is excess money inflated in the market when it is not needed or at a time when it can be postponed to a further date. Government of India has resorted to measures of deficit financing that is printing of currency to fund its fiscal deficit. There has been a marked increase in social contribution schemes like MNREGA. More money is being paid to government servants as a result of implementation of the sixth pay commission. Heavy amounts are being spent on subsidies on fuel, fertilizers, electricity, etc. All this is contributing to inflation in their own way. Unless the government reduces the gap between its revenue and expenditures inflation will remain a concern. Neither RBI nor any other regulator can do anything in this. All the results have just downgraded the economy by hampering growth.

The other factor for the problem of inflation and failure of RBI policies is the supply side problems. India today doesn’t have enough storage capacity with it to store food grains. Millions of tons if left in open to rot. The demand is ever increasing and the inefficient storage system and poor infrastructure isn’t able to meet the existing demand left along the increased one. Transportation of goods, storage, production and other process all face infrastructure problems. This is the reason whole supply chain is loaded with defects and problems. Railways are over utilized and still can’t meet the needs of transportation fully despite the fact that transporting from railways is far cheaper. Roads are bad which increases time of transportation, repair costs of vehicles and fuel expenses.

The Central and State Government conflicts are also contributing to the problem. Some states don’t accept the grains sent by Central government and they are left unattended. So, how can any RBI policy tame inflation when the problem is not the one created by demand side. It’s a vicious circle created by the government. And the ministers are not willing to accept the fact.

RBI urgently needs to limit further policy rate hikes. The current 8.50% is already at a highly unhealthy level. There is a need to decrease these rates before further growth is compromised. Banks have been downgraded; investor confidence is at all time low, markets are lull. Industrial production and growth has been falling constantly. For a change to happen an initiative by the government is must. Adequate infrastructure should be built up to improve the supply side problems. Deficit should be controlled and a balance should be maintained between revenues and expenditures.

It is no fact that in a global economy no central bank or government has full control over the economic activities. However this should not stop the government and the bank to put for structural reforms. This one change may become solution for all the problems in the economy.