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When a Regulator Fails - An Analysis of RBI Monetary Policy

BY: Vivek SHARMA | Category: Finance | Submitted: 2011-10-26 04:43:40
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Article Summary: "The article highlights how the monetary policy of RBI has failed to achieve desired result of containing inflation.."


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RBI came out with 2nd quarter review of monetary policy on 25-Oct-2011. The policy once again increased repo and reverse repo rates by 25 basis points. This was 13th increase in repo and reverse repo rate since March 2010. All the rate hikes have been done with an objective to contain inflation and stability to Indian economy. However, the fact remains that inflation concerns are far from over.

Even in the current financial year, the WPI indicated rate of inflation us 9.6% which is abnormally high. Why it is that inflation has not been contained despite so many rate hikes. Though RBI has shown some optimism in this review and has indicated that the inflation may come down post December,2011. However, RBI is itself not sure about it and has indicated that there are serious causes of concern on inflation front.

The RBI in its second quarter review has stated that ,' Going forward, the inflation path will be shaped by both demand and supply factors. First, it will depend on the extent of moderation in aggregate demand. Some signs of demand moderation are evident, although the impact is being felt more on the investment side. Second, the behaviour of crude prices will be a crucial factor in shaping the outlook of domestic inflation in the near future. The benefit of a decline in global crude prices in the recent period has been more than offset by the depreciation of the rupee in nominal terms. Thus, the exchange rate will also have some impact on the behaviour of domestic petroleum prices. Third, the inflation outlook will also depend on the supply response in respect of those commodities characterized by structural imbalances, particularly protein items. Finally, there is still an element of suppressed inflation in the economy. Domestic prices of administered petroleum do not reflect the full pass-through of global commodity prices. Prices of coal and a few other commodities do not reflect the current market conditions. As and when price adjustments take place, they will add to inflationary pressures'.

These four points mentioned in the review document are clear cut indication that the inflation may or may not fall in the days to come. Is crude price in the control of RBI or can RBI handle supply side constraints? The answer is emphatic no. Then why is it that RBI has been increasing repo and reverse repo rates continuously. RBI has believed that by reducing money supply, demand for money can be reduced, which will pull down inflation. This is where effectiveness of monetary policy has always been questioned. RBI policy over a period of 18 months (since 2010) has been successful in slowing down growth but has failed to reduce inflation.

Had the situation been worse off without RBI policy measures? Not really, current global economic scenario explains this. When the crude oil price started falling, Indian rupee depreciated resulting in a petrol price hike once again. Hence inflation is in control of global and domestic factors more than RBI. Look at supply of foodgrains in the economy which can help curb food inflation. However RBI has no control on this.

While RBI was an extremely successful regulator in handling 2008 global crisis in terms of its impact on Indian economy, in the current scenario the regulator has failed. As a part of policy measures rate of growth has come down while inflation continues to be high. Isn't it right time when the regulator should stop intervening through repo and reverse repo rate hikes?

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Comments on this article: (1 comments so far)

Comment Comment By Comment Date
Very interesting perspective. Keep up your good work sir. Gaurav Dixit 2011-10-27 05:26:10 976

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