Friday, 8 November 2013

Inflation - RBI's First Priority

In its mid term policy RBI has again stuck to its priority for curbing inflation. RBI has clearly signaled that its first priority is to curtail inflation even if it is at the expense of growth to some extent. The question is, why is inflation so important? Why is the RBI so seriously worried about inflation and made it its number one priority?

To understand the importance of inflation we first need to study the causes of inflation and its widespread effects.

Causes of Inflation :

  • Supply side constraints.
  • More demand which is not being met by sufficient supply.
  • Depreciation in the value of currency raising the cost of goods by that much proportion.
  • Boost in consumption due to reasons like social welfare schemes. This will cause inflation because this boost is not due to genuine rise in income or livelihood but artificially created by giving subsidies etc. Though in itself it is not a bad thing, such schemes cause inflation as a side-effect.
  • Growth creates inflation as a side-effect. Economic growth is driven by sustained demand which is good for the economy. Where demand increases, inflation exists. However, presently a demand-supply gap is very wide and is causing uncomfortable levels of inflation.

Effects of inflation :

  • In India, the inflation is presently at high levels of 9% and above on an average. If the RBI is not tough on its stand and reduces interest rates thereby increasing liquidity, the inflation will be in an upward spiral increasing to double-digits. 
  • This will create a price bubble in the assets making things more costlier and out of reach of common man.
  • Increase in inflation will erode the value of financial savings and investments. The return from many financial instruments will not be able to keep up with such a fast increase in price. The inflation adjusted return will be in the negative. For a detailed view on this visit Inflation - Effect on Investment.
  • Inclusive growth will be hampered.
  • Govt. fiscal deficit will widen through higher subsidy bill.
  • Savings will be channelled into physical assets rather than financial assets.
  • Growth will be hampered due to the high costs of materials. This will be compounded by other problems like high CAD and fiscal deficit.
  • Value of currency gets depreciated in the forex market leading to depletion of forex reserves.

Logic of RBI’s actions :

Sustainable healthy inflation with growth is more rewarding than high unsustainable inflation. Presently India is trapped in a cycle of low growth, high inflation and low capital investment.

It is important to understand that RBI is not the sole player in regulating inflation. Govt. policies also have a major part to play. RBI’s primary mandate is to maintain price stability. To achieve this objective the comfortable figure for retail inflation index is 5%.

If the RBI does not counter the present high inflation by restricted & cautious monetary policy, inflation will be in an upward spiral taking the presently high figure to even more uncomfortable heights. In the present situation there are many supply side bottlenecks which need to be cleared by streamlining the govt. policies and back end infrastructure. The only way to put brakes on inflation till such constraints are cleared, is to keep interest rates high and low liquidity with stable currency.

Readers can visit this post for steps taken by RBI to stabilise currency after the recent depreciation.

The RBI’s stance is that the major cause of inflation is supply side constraints over which RBI has no control. The RBI can only dampen the demand but cannot increase supply.

Govt. has started doing its part by clearing stalled projects and thereby trying to improve investment climate in the country. This will improve the economic activity in the country. The end effect of such economy friendly steps by the govt. will be to stimulate growth.

But these steps initiated by the govt. will take time to show effects. Till such time, the interest rates are bound to remain high and RBI will continue with its tough stand.

Till such time we can only say “Godspeed India”!!