Economist Milton Friedman said that inflation is always a monetary phenomenon. This is the bedrock of monetary policy. Theoretically speaking, by increasing interest rates one can slow down the demand for money, which in turn slows down demand in general and thus controls inflation.
But today, inflation is of a different variety. Crude oil prices are rising, pushing up energy costs. Supplies have been cut due to the disruptions caused by war, widening the demand-supply gap. When edible oil prices increase in global markets, it is more a case of supplies being lower. Metal prices, however, have risen — demand has gone up due to the China factor, and as there are time lags between increasing demand and adjustments in supplies, higher prices prevail.
This leads to the question of whether changing interest rates can control inflation. In India, food price increase is mainly due to supply issues. At a point in time, it was argued that demand for protein-based products like pulses and meat rose sharply, leading to inflation. But more often, it is a case of lower production that causes prices to rise. This is why there is a fear of sub-normal monsoon which can lead to an increase in food prices. Clearly, a higher repo rate cannot bring down these prices.
The core inflation basket is also interesting. When prices of food in restaurants, hotels, etc. go up, it is a clear case of outlets increasing prices to make up for higher fuel prices and other inputs. Gold prices go up when global rates rise and any increase in the interest rate cannot quite reduce demand or price. Petrol and diesel prices depend on the decisions of the government and oil manufacturing companies. The repo rate, again, has little effect.
How are interest rates set? When rates are lowered, the cost of credit comes down, and producers can borrow at a lower cost. Individuals may be better off taking personal loans or buying houses and vehicles. However, as all lending rates are fixed to the benchmark for retail loans, the borrower knows that during the phase of the loan, costs can go up or down depending on when the rates are re-set. Hence, while lower rates assist in taking a decision, it cannot be the clinching factor. When interest rates are raised, businesses pay more and are judicious with borrowing. But will this bring down inflation?
Last year, inflation rates were benign due to lower prices of agricultural products. The base effect works both ways because extremely low inflation in FY26 was due to high inflation in FY25. This will always happen. To say that inflation was conquered in FY26 would be hasty.
The other oft-cited explanation is inflationary expectation. It is argued that when inflationary expectations increase, they get built into prices and become self-fulfilling. However, if the knowledge of a tomato crop failure enters into prices today, it is the knowledge of the crop prospects that affects the prices. But for manufactured products, companies mostly do not increase prices if they expect inflation to be higher going forward, as they would examine all conditions, including demand, before taking a call.
Hence, for monetary policy action, the following points are important. First, high inflation or a trend of rising inflation posits the merit of raising rates to ensure that the extant excess demand forces drive up prices. This also covers cases of shortfall in supply.
Second, increasing the repo rate is a signalling mechanism for discretion in lending. Higher interest costs make companies factor in this component when planning any investment decision. A repo rate hike automatically feeds into all other markets. In fact, successive hikes ensure that borrowers know the future direction and adjust their plans.
Third, the repo rate change adjusts to inflation to provide the real rate, which is important when it comes to savings and investment. This is where there has been considerable debate on the ideal level. There is no rule as such. But if it is negative, there is reason to believe that savings are going to be affected, especially bank deposits. Here, policy should be forward-looking, as the real rate will make savers take a call on where to put their money. In this context, policy is most effective as it sets the contours for savings and investment.
On the other hand, when rates are lowered, the demand story gets into play. People borrow more, as do companies, which in turn pushes up demand and hence growth. The Keynesians hence have the last word when it comes to linking monetary policy with growth tendencies. Growth can be a monetary phenomenon.
Therefore, monetary policy must be nuanced and calibrated with inflation to maintain an equilibrium on the real interest rate. And this may have to be forward-looking in terms of future inflation to enable decisions.
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.