The war against inflation needs support of government, which needs to reign in fiscal deficit, improve supply of foodgrains and needs to desist from taking populist measures

The Reserve Bank of India (RBI) took the financial markets by surprise when it decided to increase the repo rate by 25 basis points in its mid-quarter policy review. What has surprised market experts even more was the fact that Raghuram Rajan, the new governor of RBI, continued the legacy of his predecessor much against the expectation that was built in the market before the policy announcement. While the repo rate increase had a surprise element in it, what has surprised more is the continued belief of RBI in monetary policy acting as an effective tool for containing inflation.
 

The RBI governor was categorical in his statement that inflation control is the most important agenda for the central bank. RBI has been fighting against inflation for a long time with limited results. There are two basic flaws in RBI’s approach towards containing inflation.
 

The first flaw is its obsession with Wholesale Price Index (WPI). WPI is a very misleading number, as the majority of Indians are not impacted by it. In fact, WPI is a myth as far as the common Indian household is concerned. The Indian consumer is hardly impacted by WPI, as there is a big gap between retail price and wholesale price. It is possible that when wholesale price appears to be in control, retail price will not actually be in control. The policy measures should be focused on a more broad based retail price index, which is much broader than the existing Consumer Price Index (CPI). Unfortunately, this is not the case and RBI’s obsession with controlling inflation gets reflected in the fact that it always analyses effectiveness of policy measures with the changes in WPI numbers. There is an occasional mention of containing CPI with emphasis on food inflation.
 

The second flaw in RBI’s approach towards inflation is the conviction that repo rate is an effective tool to contain inflation. Does repo rate always help in containing inflation? Is inflation a purely demand-push factor? Can it be controlled without managing supply side constraints? How can repo rate be effective if international crude prices go up? Also, with ever-increasing wages in rural areas supported by government policy measures and in urban areas because of ongoing business activities, is it possible to arrest the rise of inflation? Can RBI control inflation, when the government decides to give semi-annual dearness allowance hike of 10% to its more than 50-lakh employees, thereby adding substantially to purchasing power?
 

The flaw in the RBI policy can also be analysed by looking at the most core concept of inflation, which is food inflation. Food inflation is a predominantly supply side issue. We need good crop harvests to control food inflation and repo rate hike cannot be effective here.
 

Another flaw in RBI’s usage of repo rate as a policy measure to contain inflation can be understood from the data released by RBI from time to time. Let us look at the data below:
 

Repo rate and WPI do not move in tandem. Inflation is driven by a set of macroeconomic factors, both from demand side and supply side. There have been instances when inflation has gone up despite RBI increasing the repo rate. In April-October 2008 phase, the WPI number went up even though RBI increasing the repo rate. It did come down after that not because of increase in repo rate. This happened predominantly, because of the global slowdown and the softening of commodity prices, including crude prices. Inflation  again started picking up post July 2009 when the government tried to revive the Indian economy through a series of stimulus packages. The RBI reacted by increasing rates and 13 consecutive rate hikes were done which stifled economic growth.
 

Inflation cannot be controlled by monetary policy measures alone if other issues such as supply side constraints, fiscal policy measures and global economic environment are not conducive for it. The war against inflation needs support of government, which needs to reign in fiscal deficit, improve supply of foodgrains and needs to desist from taking populist measures. Protecting Indian economy from vagaries of international economic movements has to be part fighting inflation. If RBI continues to operate with the noble intention of containing inflation with inappropriate policy measures, we will end up having a high interest rate, low rate of economic growth and a potentially, higher than required inflation. It is time to rethink effectiveness of repo rate hike as a policy measure.
 

(Vivek Sharma has worked for 17 years in the stock market, debt market and banking. He is a post-graduate in Economics and MBA in Finance. He writes on personal finance and economics and is invited as an expert on personal finance shows.)