Citing “uncertainty over domestic inflation”, the Monetary Policy Committee (MPC) has opted for back-to-back repo rate hikes, as a result of which the borrowing rate for banks from the RBI now stands at 6.5 per cent. The RBI’s concern over rising trade protectionism spilling over to currency wars is understandable, but what is not are its views on domestic growth-price dynamics. While responding to a creeping rise in retail prices, the MPC does not seem to have taken into account its essentially cost-push (for which a rate hike is no answer) rather than demand-pull character. Even as a combination of rupee depreciation and rising fuel prices has spurred headline inflation, there can be no denying that governments’ (Centre and States) unwillingness to reduce excise duties has exacerbated matters. Higher interest rates will merely add to the costs of producers while curtailing demand, at a time when the economy is showing signs of a rebound. The MPC seems to have confused an incipient growth recovery with signs of demand excess, by making a case for addressing the latter. It has hence expressed concern over the hike in minimum support prices, in the process overlooking signs of a rural demand constraint borne out by farmers’ agitations. The MPC’s view that “robust corporate earnings, especially of FMCG companies, reflect buoyant rural demand” is, therefore, somewhat contestable. Given the paucity of reliable data, it is not as yet clear whether “investment activity remains firm” or wage and employment levels are rising.

The MPC’s assertion that the “output gap (the gap between an economy’s potential and actual output) has virtually closed” seems inappropriate in view of the largely unorganised nature of India’s economy, where ‘potential’ and ‘actual’ levels of output and employment cannot be easily ascertained. It seems to be targeting a headline inflation figure of 4 per cent (notwithstanding the base effect of low inflation in 2017), without allowing itself the two percentage point band that is written into the policy. Indeed, it is time to reconsider ‘inflation targeting’ for its implications on growth. It does not seem to have worked very well (raising inflation rates, for example, in the US) in other parts of the world.

The MPC’s quixotic reading of the domestic economy gives rise to the question of whether it is raising interest rates essentially to shore up the currency and check capital flight in these skittish times. Its concerns on this score are valid, with signs of capital movement from emerging markets back to the dollar. However, the best approach to managing the currency is to boost economic fundamentals. There are limits to using interest rates as an instrument to ensure stability on the external account. Less blunt methods could work better. Finally, the lack of quality data on employment and industrial output poses a constraint to policymakers both at Mint Road and North Block. This needs to be addressed.

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