Taming Inflation Vs Spurring Growth: The RBI Conundrum

In December 2011, the inflation eased to a low of 7% after hovering around 9% for quite some time. This prompted economic experts to ask for a reversal of the monetary tightening (hike in Repo and Reverse Repo rates) policy practiced by RBI as the high interest regime was hurting the industrial sector also. However, others are of the view that RBI should wait for some more time before acting on this counsel. Why this difference of opinion? To understand this, let’s understand the concept of inflation, interest rates and industrial growth and their dynamic relationship.

Inflation is a sustained rise in the price of various commodities in an economy, Inflation is calculated by comparing the price levels of a representative sample of commodities (since, it would be too cumbersome and time consuming to take into account all commodities sold in the market) in the current year to the prices during the same period in the last year. For instance, if the price of a commodity X, which was available at Rs 10 in the first week of 2011, is Rs 11 in the first week of 2012, the prices have risen by (Rs 11-Rs 10=) Rs 1 or (Rs 1*100/Rs 10=) 10%. Here, price figures which are taken into account may be either the wholesale prices (the price at which the commodities are sold by wholesaler) or the retail prices (the price at which the commodities are sold by the retailer to the end-customers, i.e., he prices at which we buy the various commodities) - inflation figures so arrived at may be described as based on the Wholesale Price Index(WPI) in the former case and Consumer Price Index (CPI) in the latter. Experts opine that CPI based inflation is nearer to ground reality as it reflects the actual impact of price on the general public. However, in India, inflation figures are based on WPI. Incidentally, we are migration to the CPI based regime but this process would take around 2 more years.

Inflation can be caused by many factors. For instance, if the demand for a commodity is much above than the supply, the price of the commodity would rise. It so happened in 2010 that a slump in sugarcane production led to decreased production of refined sugar causing its prices to rise in the open market. Inflation in this case is due to high demand and hence called demand led inflation. On the other hand, the recent rise in rubber, iron and steel prices have led to an increase in the production cost of automobiles with the consequence that their prices have been hiked by the manufacturers. The inflation caused by such a price rise, which was necessitated not because of an increase in demand but rather a rise in the input costs (cost push factors), is called supply-led inflation. The expected increase in oil prices, due to international ban on oil imports from Iran would increase the transportation costs of fruits and vegetables and so their prices may increase-the inflation thus caused would be supply led inflation.

Now, let’s move onto the monetary tightening done by RBI in the last few quarters. RBI has many instruments to control the quantum of money circulating (liquidity) in the market but we shall restrict our discussion to those relevant for our discussion-Repo and Reverse Repo Rates. Repo stands for Repurchase Agreement called so because a bank sells government bonds and securities in its possession to RBI in lieu of money (loan) to meet its short term requirements and agrees to repurchase the same bonds and securities at a later date by returning the loan as well as interest amount. Thus, the Repo Rate is the interest charged by RBI on such short term borrowings by the banks. If the Repo Rate is low, the banks would want to borrow more from the RBI while a high Repo Rate would discourage banks from borrowing as that would entail a higher interest outgo on the borrowed sum.

Reverse Repo, on the other hand, is a Reverse Repurchase Agreement-the process through which RBI borrows from the banks. The Reverse Repo Rate is thus the interest paid by RBI on such borrowings from the banks. It is amply clear that if this rate is high, the banks would get a higher payment for their funds parked with RBI and so would want to lend to it. On the other hand, if the Reverse Repo Rate is low, they would not be enthusiastic to lend to RBI.

Let’s look at the two rates from RBI’s perspective. If it wants more money to be available with banks (easing up the liquidity), one-it would encourage borrowing by the banks by decreasing the Repo Rate; and two-it would decrease Reverse Repo Rate also so that banks opt for keeping their excessive money with themselves rather than parking it with the RBI. Conversely, if its objective is to decrease the money availability with the banks (liquidity tightening/drying up the liquidity), it would increase the Repo Rate (to discourage borrowing from RBI) and the Reverse Repo (to encourage banks to park their excessive money with RBI) rates. Thus, both the Repo and Reverse Repo Rate would move in tandem-either both increase or both decrease as this would give a very conflicting signal.