Higher policy rates impact inflation mainly through the bank lending channel and the exchange rate channel. RBI and the government now need to ensure that these channels work efficiently so that inflation is conquered and further rate hikes are not required. If these channels do not work, it will require rates to be raised much more sharply than RBI may like to. For some time, banks have faced relatively low demand for credit. But as industrial growth picks up and the demand for credit rises, higher policy rates and higher CRR imply that bank credit should become more costly. Higher interest rates will keep the demand for credit in check. All banks may not raise interest rates immediately. If RBI continues on the path of tightening, one will soon see a situation when banks raise lending rates.
The second channel through which higher interest rates restrain inflation is the exchange rate channel. Monetary policy in the US and Europe is likely to remain loose for some time to come. A hike in interest rates in India pulls in capital inflows by increasing interest differentials with the rest of the world. This will help the rupee strengthen. A stronger rupee will reduce the price of tradables, and offset some of the global tradables inflation. These are primarily non-food items that shape the core inflation that RBI has been most worried about. So, the pressure on higher prices, both in the local economy and with global tradables, is partly offset through a policy of higher interest rates and a resulting stronger rupee.
RBI governor D Subbarao has said in some post-credit policy interviews that RBI is not using rupee appreciation to control inflation. Regardless of what the intent may be, a strong rupee does help in containing inflation. If, alongside raising rates, RBI gets into trading on the currency market in order to force a strong dollar, it would be inconsistent. This will drive up the price of tradables. This will result in higher WPI manufacturing inflation and then put pressure on RBI to hike rates further, thus revealing the lack of consistency of the policy mix. Also, controlling liquidity will become difficult if RBI buys dollars to prevent appreciation. Policy could then collapse into trying to conduct capital controls to prevent inflows, creating further distortions in the market and setting off fresh trouble for RBI.
In recent days, RBI has reopened the MSS window. This suggests that they have either started buying dollars or plan to buy dollars. As argued above, this would be an inconsistent policy platform, and yield a mess (as has been seen in previous years when RBI tried to prevent rupee appreciation).
In the current environment, when politicians are focused on the inflation rate, RBI must clearly say to the government and to the larger public that it cannot simultaneously fight inflation and induce distortions in the exchange rate. RBI doesnt face pressure from lobbies, but the government does. The resolution of this conflict is a political decision. It is when such conflicts arise that central banks have been able to make their life easier by adopting inflation targeting as their objective. If the government wishes to support exporters, then instead of doing it through exchange rates that distort monetary policy and prevent RBI from attacking inflation, the government should do it through direct subsidies. Former finance minister P Chidambaram once pointed out that MSS interest payments, which have amounted to more than Rs 3,000 crore a year in the past, are an export subsidy.
Instead of such a subsidy, which simultaneously distorts monetary policy and induces high inflation, exporters should be given a direct on-budget subsidy. In summary, RBIs move on tightening monetary policy will only be effective if it is accompanied by a strong rupee.
The good news might be that thanks to the slowing down in food price inflation, overall inflation could stabilise at 6-7% by July. Higher food prices can spill over into higher inflation by pushing up the CPI and thus putting pressure on wages to rise. Rising input costs, both due to higher commodity prices and due to higher wages, can lead to a second-round effect on inflation. But with a lower base effect, a stronger rupee and some tightening, it is hoped that over the next two months inflation rates will stabilise. However, there may be further hikes, perhaps even before the next credit policy, if inflation and growth numbers remain high. RBI seems to be in a mood to wait, watch and move rates slowly rather than to make big moves. This bodes well.
The author is senior fellow at National Institute of Public Finance & Policy. Views are personal