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Monday, June 6, 2011

Inflation: Can Monetary Policy Rein It In?

“A necessary condition for inflation targeting to work is efficient monetary transmission. 
In India, monetary transmission has been improving but is still a fair bit away from best practice,” is what the Governor of the RBI had got to say recently. A candid observation, indeed. As the inflation is persistently remaining high—9.04% y-o-y in March, which, of course, eased to 8.6% in April—this observation acquires greater significance.

Across the globe, central banks resort to influencing market interest rates through changes in their short-term rate, often called policy rates, so as to manipulate the money circulation in the system as a whole in such a way that it ultimately influences the general price behavior of goods in the market in the desired fashion. To begin with, any change in the policy rate of central banks first reflects in the interbank rates and then in retail rates such as credit extended to investors and businesses. It is this transmission of change in central bank’s policy rate to market rates is what is called monetary transmission, and the speed at which this transmission occurs is what matters most in managing the inflation and stabilizing the prices.

Most of the central banks usually prescribe the ceiling and floor rates to set a corridor around its policy rate so as to ensure that the interbank rates for overnight borrowing remain close to its policy rate that incidentally acts as the ‘anchor rate’. In the absence of an anchor rate, interbank rates are likely to fluctuate widely from one end of the corridor to the other, even outside of it too.

Indeed, that is what happens in our case—as we do not have a single anchor rate, but a repo rate at which the RBI lends money to banks (ceiling rate) and a reverse repo rate at which banks can lodge their excess liquidity with the RBI (floor rate), quite often the overnight interbanking borrowing rates shoot above the ceiling or floor rates. So, the introduction of a single anchor rate is more likely to reduce these wide swings, leading to the right transmission of intended policies. Of course, in our case, this in itself is not sufficient to improve the transmission.

There are a few other reasons for this breakdown in the transmission. For instance, if the commercial banks have enough liquidity by virtue of an asymmetric relationship between depositors and banks’ interest rates, they, obviously, do not need to borrow from the central bank, because of which a mere rise in the policy rate by the RBI cannot push up the market interest rates, and this indeed is what happens many a time. In the current global economic scenario, the loose monetary and expansionary fiscal policies practiced by the developed West have resulted in lots of foreign capital flooding the system through stock market, which suddenly creates liquidity in the system. Similarly, the role of the RBI as debt manager of the government—auctioning of government securities and maintaining its cash—comes in the way of monetary transmission. There is also a complaint that the administered interest rates on postal savings that are not adjusted in alignment with the monetary policy stance of the RBI tend to weaken the transmission. Similar is the effect of not having an active secondary bond market that is essential to have a good yield curve which is known to influence credit disbursals.

Over and above all this, our economy is saddled with another challenge—the challenge of black money. The size of the parallel economy that is in operation is so big—estimated to be 20% of our GDP—that its output matters in estimating the liquidity or no liquidity in the system. But as it operates totally outside the purview of regulations, it never submits to the dictates of monetary policy. And to that extent, the impact of monetary policies on price control stands weakened.

The net result is: inflation control is a big enigma, both to the RBI and the government. And it is more so when the rise in prices is more due to supply-side constraints, for “monetary policy…is an ineffective instrument for reining in inflation emanating from supply pressures.” But for a consumer, it is one and the same: suffering.

GRK Murty


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