The Hindu Business Line : Shift in RBI strategy to fight inflation?

A vigorous debate is on in the economics world on the inflation-fighting credentials of a strong (and appreciating) rupee. One school discounts the idea that a stronger rupee can help lower inflation saying that the pass-through effect from exchange rates and import prices on to domestic prices is weak in the Indian context. Therefore, the Reserve Bank of India allowing the rupee to rise could lead to a double whammy, this school points out. Not only will inflation not be contained. Exports will get choked by the rupee’s strength and that will drag the overall growth numbers down.

The other school points out that the RBI allowing the rupee to rise and its possible impact on inflation need to be seen from the demand side. The argument is that the RBI refraining from buying dollars in the open market would result in a lower growth of the credit and money stock aggregates.

That would reflect in a lower level of demand in the economy — from the household and business sectors. If sustained, that lower level of demand would have a significant dampening effect on inflation, goes the counter argument.

That is, the contraction in the growth of reserve money (or the monetary base) caused by the RBI reducing the scale of its forex market intervention would slow the expansion of broad money (or the overall money supply in the economy) and that in turn would serve to moderate aggregate demand and price pressures in the economy.

As the debate continues, the rupee has risen to 40.60 from its recent 40.90/41 levels against the dollar. This rise in the rupee’s level has also coincided with a sharp drop in the Wholesale Price Inflation (WPI) to 4.30 per cent from the 6.50 per cent levels in late March/early and mid-April.

The RBI Governor has also observed, almost contemporaneously, that while the central bank would strive to keep the inflation rate around 4/4.5 per cent this fiscal, it would be ideal or optimum for the economy to work towards a 3 per cent inflation level for the medium-term.

What drives inflation lower?

Even the most ardent proponent of the school that advocates rupee appreciation (or rather the RBI’s abstinence from the forex market intervention) to contain inflation would agree that the recent moderation in the wholesale price inflation is not due to the local currency’s sharp rise in the past few months. The drop in the inflation numbers is more the result of a statistical base effect.

While still welcome, since it shows some moderation in the underlying demand pressures, the challenge for policy-makers will be to ensure that the softening in demand noticed recently is sustained.

It is also likely that inflation containment is aided, going forward, by the pass through effect from exchange rates/import prices on to the domestic price level.

The question as to whether the RBI, in the ensuing period, takes recourse to the rupee appreciation route or explicit interest rate hikes to keep demand in check assumes significance in this backdrop.

A study of the central bank’s policy stance over the past two and a half years — from around late 2004/early 2005, when it started raising rates, its aggressive forex market intervention in this 2 period and movements in some broad monetary data over a longer time period (10 years from 1995) — indicate a possible significant shift in the RBI’s overall strategy towards inflation, liquidity and exchange rate management.

It is quite likely that after a 30-month campaign by raising rates while at the same time intervening aggressively in the forex market (buying dollars), the RBI has decided to provide some relief to the overall economy from rising rates. Further appreciation in the rupee, while it could be damaging to the exports sector, could spare other segments of the economy the burden of rising rates.

That relief on interest rates could come from two sources. One, the avoidance of further central bank rate hikes in the first stage. More enduringly, a general softening of market interest rates as overall demand in the economy cools without the fuel provided by the RBI adding to the monetary base by its forex market dollar purchases.

Therefore, other things remaining unchanged, one should expect further rupee appreciation into the second half of this year as the RBI continues to stay away from the market. A further sustained softening in inflation from the current 4.50 per cent levels, though, could see the RBI back in the market buying dollars.

Signals from the ratios

Long term trends in key monetary ratios such as the broad money multiplier and the velocity measure of the money stock support the view that the RBI may have effected such a policy shift as indicated above.

As the Table shows, the money multiplier (M3/RM) has displayed a secular upward trend whereas the GDP/M3 ratio (the velocity of money) has shown a secular downward trend.

That long-term trend decline in the velocity of broad money is cause for concern as it means that a unit of broad money (created by the banking system acting on the monetary base provided by the RBI) results in lower and lower final output of goods and services.

To that extent, the pressure on aggregate supply is higher and prices tend to move higher in that scenario. The GDP/M3 ratio does get affected by the increase in the demand for money (where people wish to hold more money in their portfolios) so that the velocity measure is reduced. But a long term declining trend cannot be explained only by an increasing demand for money.

Overall, the RBI strategy on liquidity, inflation and exchange rate management may have undergone a significant change in the recent past. Intervention in the forex market could become more selective and more phased out as we go forward.

More Stories on : Economy | RBI & Other Central Banks

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Fading sheen of non-alignment

Toys lead to US-China trade squabbles

Good rain!

Measuring happiness

Shift in RBI strategy to fight inflation?

Stock market on a high — Lack of euphoria, a sign of maturity

The engineer behind the giant

Civil service reform

Water harvesting