Does the RBI have any real say in controlling inflation in India?

The key variable at play is the repo rate; it is the interest rate at which the RBI lends money to the banks. As such, it tweaks the interest rates in the whole economy.

The conventional thinking is that if the RBI wants to contain inflation — which is nothing but the rate at which the general price level is going up in the economy — then it should raise the repo rate. Doing so will make new (and even existing) loans costlier, thus curbing demand — both for consumption (like buying a new car or house) and investment (like building a new factory) —and dragging down overall economic growth. Alternatively, if inflation is low and economic growth is stuttering, the RBI cuts the repo rate and, by the reverse logic, incentivises new loans and fresh economic activity and output.

To a lay observer, this is exactly how things have panned out over the past year. Inflation touched an eight-year high in April last year. So in May 2022, RBI convened an emergency meeting and raised the repo rate. In fact, it continued to do so in every meeting — it meets once every two months — until April this year when it finally paused. Since then inflation has come down sharply and it is expected that on Thursday, too, RBI will announce a pause.

But what if someone told you that RBI’s policy actions (repo rate hikes) were akin to a kid turning the fake steering on their miniature car? The fake steering gives the kid a sense that the car is turning because of his actions but in reality it is the parents who are making the car turn. In other words, what if RBI’s actions had no bearing on inflation coming down.

Well, in a new paper titled “Monetary Policy in the Midst of Cost-push Inflation”, published in the Economic and Political Weekly, researchers Zico Dasgupta (Azim Premji University) and Indranil Chowdhury (PGDAV, Delhi University) show that India’s monetary policy actions had little to do with inflation coming down. As such, they suggest that India should reconsider the so-called “inflation-targeting” regime (which was introduced in 2016) whereby the RBI is solely responsible for reducing inflation in the economy.

There are two main reasons why RBI raising rates is ineffective in India.

One, the salience of the phrase “cost-push” inflation.

If the prices are rising because of higher oil prices or higher food prices or both, how will raising interest rates bring down inflation? In India, for instance, the government levies a whole host of taxes on petrol and diesel. If the government wanted to ease inflation, the better way out would have been to simply reduce the taxation component, which is often almost as much as the basic price of the oil itself.

Of course, letting go of these taxes would lead to a gap in the government Budget but that is a different matter; to be precise, it is a policy choice that a government can make: choose between suffering some Budget deficit (or levying some other tax to bridge the deficit) while relieving the common man of high inflation.

To be sure, this is a raging debate across the world, including the US. More and more people are asking why central banks (via monetary policy) have to drag down GDP and push people out of employment just to contain inflation when the source of inflation is elsewhere and is, in fact, better handled through fiscal (government) policy.

Two, the salience of India’s labour market.

The typical counter to the first point is that without dragging down GDP (through higher interest rates) it is not possible to bring down inflation. That’s because with higher GDP, more people get employed and this raises their ability to buy things and bargain. And this, in turn, raises inflation.

But, as Dasgupta and Chowdhury, point out, in India higher GDP does not come from higher employment. As such, dragging down GDP doesn’t really bring down inflation.

The question then is: If RBI’s repeated interest rate hikes did not bring down inflation then what did?

The answer lies in the sharp reduction in crude oil prices over the past year as well as the surge in domestic agricultural production. Readers will recall the recent celebrations about a high GDP growth rate in 2022-23 thanks to a surge in the agriculture sector. Crude oil prices, too, have plummeted by almost 40%. Not to mention that India is increasingly buying oil from Russia at discounted prices.

Then the obvious counter is: But fuel prices have not changed at the petrol pump. Then how come lower prices are bringing down inflation?

To that Dasgupta says (over a phone conversation) that while the direct effect might be muted, the indirect effect of lower oil prices is at play.

All this still leaves one key question unanswered: Didn’t the global crude oil prices fall because the US Fed and the European Central Bank and the rest of the central banks went for interest rate hikes? If that was the reason for a fall in crude oil prices and inflation then why question RBI’s decision to raise interest rates?

It is here that Dasgupta points out to the most perverse outcome of RBI’s actions.

In his view, given the realities of India’s labour market and the cost-push nature of inflation, the RBI could have easily been a free-rider. In other words, domestic inflation would have come down even without RBI raising interest rates, thanks just to the action of other central banks.

And here’s the perverse kicker: That RBI raised interest rates so sharply in the past 12 months likely worsened the situation for Indians (by raising their EMIs) at a time when they were getting hit by high inflation.

To be sure, Dasgupta and Chowdhury are not alone. Read this edition of ExplainSpeaking to understand why other academics have already questioned India’s inflation-targeting regime.

And if you want to read more about the curious impact of monetary policy on inequality, then read this edition of ExplainSpeaking.

As usual, share your queries and convictions at udit.misra@expressindia.com

See you on the other side of the RBI pause.

Udit