Come January 29, the Reserve Bank of India (RBI) will have a third-quarterly review of monetary policy to take stock of the current liquidity scenario and inflation. This meeting has gained importance especially at a time when Indiaís current account deficit (CAD) has widened to 5.4% of GDP in the September quarter, the widest in absolute terms since 1949. This also explains why the rupee continues to slide, something that was a common phenomenon over the last one year. If the value of the rupee continues to decline in this fashion, RBI will have no option but to intervene, which means buying dollars and selling rupees. This can be inflationary.
So, will the widening CAD and fiscal deficits undermine RBIís efforts to control inflation? From a laymanís perspective, inflation means a rise in the price of essential commodities. In the parlance of economics, the price of any item rises when there is more demand relative to supply. Managing inflation, therefore, amounts to managing the demand for the product experiencing a rise in prices, or by increasing the supply of this item. In the case of managing a recession, exactly the opposite chain of events should take place. Before we go into how effective RBI has been in managing inflation, it is important to know what constitutes these demand and supply-side factors.
Among demand-side factors, consumption expenditure is important. In India, consumption expenditure contributes close to 65% of our GDP. The other components are private investment expenditure, government expenditure and trade. RBI can only be successful in controlling inflation if the rise in interest rate (read, repo and reverse-repo rates) reduces consumption, private investment and government expenditure.
Three important assumptions are necessary for RBI intervention to be successful. First, there has to be a perfect pass-through in terms of the change in repo rate and reverse-repo rate leading to a corresponding change in lending rates of commercial banks. However, in reality, the pass-through is not perfect, and happens with a lag. Second, if prices rise more than proportionately in spite of RBI increasing nominal interest rates, it implies a fall in the real rate