Why RBI Should Not Increase Interest Rates To Tame Inflation

Inflation is the talk of the town across the globe. Developed economies like the US are facing historical levels of inflation at 8.3 per cent and the situation is similar in the Eurozone, where 19 countries are battling accelerating inflation. The inflation number in May rose to 8.1 per cent from 7.4 per cent in the Eurozone. Interestingly, this is four times higher than the European Central Bank’s comfort level of 2 per cent. 

Where Does India Stand?

On the domestic front, the Consumer Price Index (CPI) inflation is on the rise since October 2021 after touching a low of 4.35 per cent in September 2021. In January 2022, it crossed the Reserve Bank of India’s (RBI’s) comfort level of 6 per cent with a rise of 6.01 per cent. Despite this, RBI’s rate setting panel, the Monetary Policy Committee (MPC) on February 10 left the key rates unchanged and persisted with its accommodative stance. The MPC maintained the repo rate (the rate at which RBI lends short-term funds to banks) at 4 per cent and reverse repo rate (the rate at which the banks park their funds with RBI) at 3.35 per cent. In April too, the RBI did not hike the rate and gave a pleasant surprise to the market.

However, RBI surprised the market with an unscheduled announcement on monetary policy on May 4, 2022. RBI hiked the repo rate by 40 basis points (bps) to 4.40 per cent with immediate effect. While announcing the policy, RBI Governor Shaktikanta Das raised concern about food inflation.

According to the latest data released (on May 12, 2022) by the Ministry of Statistics and Programme Implementation, India’s retail inflation rose by 7.79 per cent on April 2022, which is the highest since May 2014. Food inflation, which is measured by the Consumer Food Price Index (CFPI), rose even higher, reaching 8.38 per cent compared to 1.96 per cent in April 2021. 

The pertinent question here is what causes higher inflation and is interest rate hike alone is enough to tame it.

What Causes Higher Inflation?

To get the answer, you need to delve deeper into the CPI constituents. In CPI, food and beverages accounts for 45.86 per cent, followed by housing (10.07 per cent), transportation and communication (8.59 per cent) and fuel and light (6.84 per cent). Interestingly, in April, food inflation accelerated for the seventh straight month to 8.38 per cent, a new high since November of 2020, with cost of oils and fats (17.28 per cent), vegetables (15.41 per cent) and spices (10.56 per cent) recording the biggest rises. India imports 130 lakh tonnes of oil from different countries. The ongoing conflict between Russia and Ukraine has pushed edible oil prices sharply up and this contributes to higher inflation.

The second biggest factor was vegetable prices. There are two costs involved: production and transportation costs. Transportation costs went up because of higher oil prices. The crude prices are hovering near their all-time high. Global markets are reeling under pressure after the European Union agreed to ban the majority of Russian oil imports as part of new sanctions, which led to crude oil prices rising above $120 per barrel as on May 31, 2022.

Why Won't Further Rate Hike Help?

It is not rocket science to understand when the price of a commodity rises. It is either when there is more demand or less supply. The current scenario is not because of higher demand but because of supply disruption due to the geopolitical situation. The major cause of inflation is due to extraneous factors. RBI’s monetary policy action is primarily driven by domestic considerations of economic growth and inflation.

No Rate Hike Is Better Option

Rate hike is one of the mechanisms to curb the growth by raising the cost of borrowing and availability of funds. In the last policy meet, RBI hiked the cash reserve ratio (CRR) by 50 bps to 4.50 per cent. The CRR hike has been effective from the fortnight from May 21, 2022 and would withdraw about Rs 87,000 crore from the system.

The question is how much of inflation is credit driven and if curbing it would lower the demand and thereby inflation. If you look at the bank balance sheet, it would show that credit growth is just treading water. So, in the given scenario, rate hike will not help the situation, rather it may have an opposite effect.

Bond yields have spiked. India’s 10-year bond yield touched a three-week high at 7.46 per cent on May 30, 2022. The higher bond yield may dent the government borrowing program. On the other hand, higher borrowing cost for corporates will add to higher production cost which may translate into higher inflation. From the market point of view, rate hike will spoil the market mood and lead to higher outflow by foreign portfolio investors.

It is yet to be seen what RBI announces on June 8, 2022–whether it joins the global counterparts to tame inflation by hiking the rate or is driven by domestic considerations of economic growth.