The Hindu Business Line : RBI attacks inflation

Like a stern father dealing with a persistently errant child, the Reserve Bank of India raised the Cash Reserve Ratio (CRR) by 50 basis points in order to curb the high levels of credit expansion that despite earlier money-tightening measures has continued at 30 per cent. By raising the CRR, that will impound close to Rs 14,000 crore of bank funds thus making that much unavailable for lending and with the earlier repo rate hikes, the RBI hopes to dampen the capacity to lend and, as a result, inflation that the apex bank feels is a consequence of the highest credit expansion in years.

While acceding to the possibility that the high rate of inflation, of 6.58 per cent, has its sources in supply constraints, the RBI expects its monetary measures will have a dampening effect by curbing demand for credit, especially for retail trade and real-estate, particularly the latter, where prices have shot through the roof. Yet, the odds are stacked against the CRR and the repo rate hikes having the desired effect on inflation not simply because the epicentre of the inflationary pressure is elsewhere but because the relationship between credit growth and inflation, in India's case at least, is tenuous.

Monetary Policy works best when its target is clearly identified. If credit growth of 30 per cent is considered too high, the RBI may effect a contraction in loan expansion by making capital dearer; however, an unintended consequences of this could be to dampen productive credit too, especially for small and medium enterprises not competitive enough, like their larger counterparts, to seek cheaper capital elsewhere, either through domestic or global equity/debt. When the RBI wishes to curb inflation it deals with a nebulous target because the extent to which asset prices contribute to the general price rise is unclear. Neither the RBI nor North Block has any aggregate data on real-estate prices in the absence of an index or indices for real-estate/housing, such as the Wholesale or Consumer Price Indices that track price movements in various sectors.

In attacking inflation, thus, the RBI is shooting in the dark. It uses monetary measures with deliberation; but the script is not in its favour. Under textbook conditions, demand-aided inflation could have been tackled through interest rate changes, as it is done by central banks in developed nations. Scarcity-fuelled inflation, as in India that has had the fastest but equally lopsided growth in the last four years, requires a whole set of systemic reforms to rejuvenate moribund sectors that New Delhi has persistently shied away from. It may not be able to do so any longer.

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RBI acts to rein in inflation

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