Is RBI rate hike effective in taming inflation? - DR PANKAJ TRIVEDI & DR R K PATTTNAIK

Any further tightening will certainly have an adverse impact on growth but one is not sure whether it will have an effective control over inflation

Today, inflation control is the biggest challenge before our economy. It is not only affecting the poor and middleclass but eating away our growth prospects. Various authorities are in the process of revising GDP growth estimates. The RBI is, at its best, making attempts to keep the rising price under check. It may be recalled that during the span of two months, RBI has changed the policy rate two times equivalent to 75 basis points. Since last increase, the rise has been 275 basis points and RBI has increased rates by 10 times to control inflation and anchor inflation expectations. In this context, the moot question is: Has the repetitive increase in policy rates by RBI in the past to check inflation been successful? Headline inflation measured by Wholesale Price Index ( WPI) stood at 9.4 % with primary commodities inflation at 12.2 %, fuel at 12.8 % and manufacturing at 7.4 %. At these levels, all sections of inflation are much above the comfort zone of RBI. In view of this, RBI, as the monetary authority will take recourse to policy rate hike to control inflation and anchor inflation expectations. Two basic questions arise. First, whether changes in interest rate is really effective in achieving the goal of inflation control? Second, does repetitive increase in policy rates slow down GDP growth prospects? While, the answer to the second question could be a definite " yes" as reflected in the slowdown in the economy, the answer to the first question is inconclusive. Theoretically, interest rate is an effective tool as it represents the price of money which can be used for monetary management and thereby inflation. Furthermore, in the counter factual argument one could say that inflation could have been at much higher levels had RBI not taken monetary policy steps. Against the above backdrop, should the RBI go for policy rate increase? There is expectation in the market that RBI in its monetary policy review schedule on July 26, 2011 will increase the policy rate by 25 basis points. Some market participants also opined that the rate rise will be the last one, meaning the end of rate tightening cycle. The present policy rate at 7.5 percent has already touched the neutral rate ( threshold rate at which the growth rate will not be affected) of 7 % calculated by RBI economists and published in its Annual report 2009- 10. Any further tightening will certainly have an adverse impact on growth but one is not sure whether it will have an effective control over inflation. Notwithstanding the above argument, RBI will enhance its policy rate by 25 basis point, keeping in view money supply growth and credit growth moving at a higher rate than assumed in the Annual policy statement. Since the market has already factored this hike in their business decisions, it will smoothen market sentiments.

Dr. Pankaj Trivedi is professor and head of Finance Department and Dr. R. K. Pattanik is professor of Economics at K. J. Somiya Institute of Management Studies and Research, Mumbai