Inflation beyond control of monetary policy

The RBI has been on an 'interest hike' spree for quite some time now, but inflation has not come down. The misconception that a hike in interest rate can contain inflation is based on monetarism, propagated by Milton Friedman. The fact is that the Government can do little to check inflation in an open economy. As a corollary, if commodity prices were to fall in the event of a double-dip recession, the government can hardly claim credit for bringing prices under control. It is, of course, another matter whether commodity prices are headed southward at all.


The current spell of high inflation is also driven by high food prices and there are supply constraints in agriculture; hence, not much that can be done in the short run to check inflation. But inflation is a political issue and the government must show that it is taking efforts to check inflation. Hence these rounds of interest rate hikes!

It may be worthwhile to note in this context, that several countries have adopted the so-called policy of 'inflation targeting' since the 1990s.

Several studies have been made in this regard, but there is no conclusive evidence of the effectiveness of inflation-targeting. To be fair, it may be true that some countries, which experienced runaway inflation earlier, often in the excess of 100 per cent, could possibly get a better grip control on the inflationary pressure. But the policy of inflation-targeting was never put to serious test.


Unlike the Americans, Indians do not live by credit, and hence a credit squeeze to contain demand may really not be effective in India. When inflation is driven by high prices of food and other basic necessities, a credit squeeze can hardly help, as Indians are unlikely to buy food on credit. Inflation, in India, is also significantly driven by the black money in the economy.

In India, it is quite possible that there is already a significant degree of credit rationing in place, as people sometimes pay a bribe to get a loan sanctioned. In such a situation, an interest rate hike can raise the supply of credit, and since there is already excess demand, total credit in the country will increase.

In fact, even during a period of repeated interest hikes, expansion of credit has been quite robust, during the last several months. The Indian private sector now has significant access to the foreign credit market, which also means that even if a credit squeeze does happen in the Indian market, it may simply not be effective enough to suppress aggregate demand in the economy. A steep rise in the interest rate may be counterproductive for inflation as well. Monetarism-induced policy of fighting inflation fails to recognize that credit is an important input in the production process.

So, in a cost-push inflation situation, a rise in interest rate will also raise the costs of production, adding fuel to further inflation. In India, there is significant evidence that pricing in the short run is not market-driven, but of the cost-plus-mark-up type, and hence the possibility of interest rate-induced inflation is quite high.

Moreover, as inflation impacts different sections of the society, with the disadvantaged and vulnerable people being hurt more, a A credit squeeze can also affect different groups of people differently and the richer sections are not necessarily the hardest hit. Bigger private players may lean towards foreign sources of credit, and small-scale industries will suffer.

Government's Agenda

The recent data from the RBI shows that despite several rounds of interest rate hikes, segments like personal loans and consumer durable loans have seen higher growth, while growth in the housing loan segment has remained stable. But priority sector lending, in general, and agricultural and allied activities, in particular, have been hurt. It is not just an issue of depriving credit to the priority sector; its impact on the economy and inflation can be far-reaching.

When we already know that the current inflation is largely driven by high food and raw material prices, squeezing credit to agriculture and allied activities can only make inflation more persistent.

Under the current circumstances, it is highly unlikely that the interest rate hike will have any significant dent on inflation. So, if the government wants to give succour to the poorer sections of the people, the only options appear to be providing subsidies and strengthening the public distribution system. It is surprising that though the government has often argued that the current spate of inflation is due to factors like high global prices and higher buying power among the people due to social sector programmes such as NREGA and that nothing should be done that can hurt economic growth, it still resorts to "faith healing" in the form of raising the interest rate.

This is not to argue that economic growth is the only priority and inflation does not matter, but it is simply unacceptable that economic growth is hurt while inflation remains unchecked.

The recent downgrading of the US by Standard and Poor's has brought into focus another force that might drive the central banks towards inflation control. Rating agencies also consider inflation as a factor for downgrading a country. But high inflation and high exposure to foreign debt are not similar and they have different implications in different global situations. Moreover, rating by such financial agencies is not beyond doubt. In any case, if higher interest rate is unable to bring down inflation, downgrading would take place anyway.

Tags: subsidies, price regulations, monetary policy, inflation, globalization, economic growth, credit market