The first quarter review of the monetary policy by the RBI makes the priorities of central bank very clear. It has Inflation control on high priority and rightly so.
Inflation is affecting millions of people across the length and breadth of the nation and has to be tackled on priority. Growth definitely will be hurt over the short term but it is the price one has to pay.
But the latest hike in CRR and Repo rates has attracted criticisms from the champions of industry and also by certain academicians. let us look at the options available with RBI and try to see what else RBI could have done.
Central banks around the world use interest rates as the single biggest tool to affect changes in the money supply and hope to control inflation through this. However, though inflation is not only a monetary phenomenon. In the context of recent inflation experiences in India, fiscal solutions would do greater help. Waivers of farm loans, reduction of income taxes, and implementation of 6 pay commission report would do more harm than good so far as inflation control is concerned. States are doing no better by giving free power to farmers and giving heavy subsidy on fertilizers. The bill for all such fiscal programmes and incentives offsets the measures by RBI to contain money supply. In fact the monetary and fiscal policies are moving mutually contradicting directions. The former is sucking liquidity and the latter is indirectly injecting it by subsidies, loan waivers etc.
Therefore RBI is using its limited tools to its best from the monetary angle to contain inflation.
It is true that higher interest rates will affect growth. But one must realize that that this would be over the short term. The cash parked at the RBI by banks (CRR) would be liberalized once the inflation will come under control. This is unlike loan waivers and pay increases which are a permanent invoice to the treasury. The CRR parked would become capital over the medium term.
Beyond Horrad and Domar model, one school of economics defines growth as difference between money supply and inflation. (Growth=Money supply-inflation). Looking at the equation, money supply can be increased to increase growth, but one cannot do it without inflation increase. But one can reduce inflation by keeping money supply constant by fiscal policies and thereby increase growth. As far as monetary policy is concerned, RBI has just reduced money supply in the hope of reducing inflation thereby sustaining the left hand side around 8 percent. This is at best what it can do.
Arguing from the horrad and domar perspective, high CRR and repo rates would also augment savings(because of higher interest rates on deposits), which will turn into investment over the medium term and increase growth provided the capital output ratio remains constant.
Monetary policy can only affect growth (as well as inflation) over short terms. Once inflation is under control, monetary loosening will have to start. Sound fiscal policies should back monetary loosening if growth should sustain without intermissions.
Given the limited scope of monetary policy, RBI would continue to tighten the money supply till it feels that the tightening has had some appreciable outcome.
