Why RBI is Obsessed With Inflation...

Fri, 15 Jul Pre-Open

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Our present RBI governor has received a lot of flak for his stance on inflation. Why do we need to bother ourselves about inflation? In his recent speech, the RBI governor continued to maintain his stance on the central bank's focus on getting inflation under control. Remember, this comes at a point in time where there is an increasing pressure on the governor from the government and industry alike to cut interest rates in order to stimulate growth.

So, should the RBI follow suit with other central banks in a race to keep interest rates at the bottom? Not so fast in our opinion. There is a need to understand the cost of high inflation to our economy. Higher inflation leads to even higher inflationary expectations. This feeds upon itself and could even end up causing hyperinflation. In addition, the consequences of inflation are not evenly distributed. In a moderately high inflationary environment, that does not impact overall growth, financial savings take a hit and it also hurts the poor daily wage laborer more, whose wage is not indexed to inflation.

India has witnessed an inflation rate of about 9% from the period of 2006-2013. Our inflationary expectations have inched upwards. Small savings instruments continue to provide a higher rate of return than bank deposits. Deposit growth for banks slowed down. Thus the banks have found it difficult to lower deposit rates in turn affecting lending rates. This is visible as even when the RBI has cut interest rates, the banks have only partially passed on the rate cut to its borrowers.

But if inflation targeting is important, which benchmark should be used for this purpose? Should we target interest rates based on Wholesale Price Index (WPI) or the Consumer Price Index (CPI). Bear in mind that it is the CPI which affects the common man. This is retail inflation. According to the governor, CPI matters and is more the consequence of domestic monetary policy. The monetary policy which also takes into account public's inflation expectations and thus wage demands.

The composition of the two indices are such that food has a higher weightage in CPI while manufacturing has a higher weightage in WPI. Hence, WPI can be lower. WPI contains a lot of traded manufactures goods and commodity inputs in the basket, whose price is determined internationally. Thus a low WPI could result from low international inflation. So is the RBI then correct to target CPI, even when the food prices cannot be effectively controlled by them? The latest numbers for Consumer Price Index inflation (CPI) stood at 5.77%. The central bank has setup a target of 5% for CPI by March 2017. This would require them to continue to keep interest rates high.

We believe that regardless of the method used for targeting inflation, India's obsession with inflation is appropriate. Bringing inflation under control should be a key priority for the central bank along with keeping an eye out for growth.

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