Consequences of Increase in Interest Rate by RBI

Prof. D. Mukhopadhyay

Of late it is observed that the US Federal Reserve has increased its policy interest rate by 1.5 percentage points as a sequel to adoption of contraction monetary policy earlier this year, the Reserve Bank of India(RBI) has increased interest rate by 0.9 percentage points which seems to support the validity of the hypothesis that India sneezes when US gets cold. It needs hardly any elaboration that Indian economy is under severe pressure of forex outgo for paying towards imports about 85% of crude oil and 45% of natural gas and crude oil per barrel on an average amounts to $71 in 2021-2022 which is likely to be $105 a barrel in 2022-2023 as projected by the RBI. Inflation rate during the current fiscal is about 8% (April, 2022) which should not have been more than 4% as per the projection made by the RBI in 2015-2016.
This is important to note that inflation rate was close to 4% in September, 2021 which was within the projected inflation rate or rather it evidences the effectiveness of monetary policy adopted by RBI subject to automatic adjustment happened to be in place by the ongoing pandemic. Increase in interest rate is popular measure to control inflation and this policy is adopted by and large almost by every country from time to time to tame the unruly inflation. High Inflation is not desirable though a minimum inflation rate is inevitable to exist in the economy.
It refers to the rate of increase in prices of goods and services over a given period of time whose consequence is overall increase in the consumers’ cost of living in the country which is under the claws of inflation. Consumer Price Index (CPI) is an objective measure of inflationary effect and its impact pressures on the household budget. The percentage change in the CPI over a certain period of time is known as consumer price inflation. In simplicity, when base year for CPI is taken as 100 and current year’ calculated CPI is, say 108, it implies that inflation rate is 8% over the given period. Similarly calculation of an overall inflation rate for a country is GDP deflator, which includes non-consumer goods such as commitment on defense modernization, surveillance, and hi-tech research and development expenditures, which is very effective in sensing the indirect inflationary effect on the consumers.
Under the given circumstances, the monetary policy formulators need to bring about balanced approach towards boosting demand and consequent economic growth without applying overstimulating techniques to the economy and causing inflation. ‘Price stability’ is of paramount effectiveness since it acts as an inflation combating force. Inflation is injurious to the normal functions of any economy as it hinders economic growth . It erodes savings, depress investment, impetus in capital flight in the form of assets, precious metals and unproductive real estate Above and over all, it makes the concerned country economically unstable through socio-political unrest if it is allowed to persistently continue for longer period. RBI is responsible for framing monetary policy in order to maintain price stability and adequate flow of credit.
The bank rate, repo rate, reverse repo rate, open market operations, statutory liquidity ratio and the cash-reserve ratio are the pivotal variables used by the RBI for controlling inflation. As mentioned earlier, inflation is a sustained increase in the general price level of goods and services in an economy over a defined period of time. Each unit of currency buys lesser goods and services as a consequence of rise in general price level implying that inflation causes reduction in the purchasing power of currency and CPI measures the magnitude of loss in purchasing power of the concerned currency. GDP denotes monetary value of all the goods and services produced in a country over a specified period of time. CPI and GDP are twin indicators of condition of economic health of an economy.
Monetary policy is used at the time of recession and inflation as well for maintaining price stability and flow pf credit. During recession, aggregate demand is stimulated by increasing money supply and decreasing interest rate and during inflation, contraction in supply of money and increase in interest rate is adopted as the classical approach to managing the economy. Recently RBI has adopted the second approach for contracting money supply and increasing interest rate but consequences of such monetary policy arousing the side effects need to be addressed and timely taken care of.
This is worth mentioning that India is attributed with transition economy after 1991-1992 when socialistic pattern of economy started to incline to the market driven economy and more appropriately capitalistic pattern of economy and the transition took off in 1991-1992 and the transition process is yet to be completed. Therefore, the conventional monetary policy may not yield desired results as it needs such a monetary policy that would fit into the economy undergoing the metamorphosis of transition.
As mentioned elsewhere, it is a challenge to regulator how to achieve desired economic growth and price stability both simultaneously. Price stability and economic growth are twin performance indicators widely accepted by the economists. Growth contributes to solving unemployment problem. Besides, the regulator has to ensure stability in the function of the macroeconomic variables in general and price stability in particular. In this context, it may be mentioned that price stability stands for the condition when a low and sustainable inflation rate has no influence on an individual’s consumption, savings and investment decisions.
Price stability is instrumental in bringing about economic stabilization that leads to sustainable economic growth. Economic growth is can hardly be free of inflationary impact. During the Great Depression, 1929-30, policies for stimulating aggregate demand were implemented by almost all the countries when both the production and inflation were observed to had been increased and the related inflation was considered to be a stimulator of economic growth.
Raising interest rate to curb inflation may be substituted with exploring relationship between inflation and economic growth. As mentioned earlier, India is a transition economy as she switched to a market economy from a liberally central economic system adopted by the Government of India since inception of launching the First Five Year Plan and it continued to be in place till 1991-1992. Raising interest rate has been a popular mechanism for taming inflation and protecting the exchange value of the currency in the inflation experienced countries across the globe but this policy is not doubt free since it may work effectively in controlling spiraling rise in the price level temporarily for a short period of time and inflation rises exponentially thereafter.
The domestic currency receives impetus for appreciation but it starts to depreciate in no time thereafter. Therefore, it may be logical to formulate a hypothesis that ‘higher interest rate on money exacerbates the stop-and-go cycles’ and nothing more. Therefore, raising interest rate may not yield the desired outcome and more chance is likely to depress the economic activities further and employment opportunities may be pruned and consequently aggregate demand would eventually come down. This is the time when the monetary policy should take care of demand management and adopting an act of balancing between inflation and economic growth. Further, inflation experienced by the Indian economy is not entirely caused by domestic-economic phenomena and right now inflation is driven by global geopolitical unrest mainly owing to military conflict between Russia and Ukraine and almost all the countries including India became the subject to the adverse impact of such economic crisis as a consequence of such military conflict.
Under the given backdrop, the monetary policy for increase in interest rate may not help the Indian economy as this is a global economic crisis somewhat similar to 2008-2009 when inflation was observed to be abnormally high on food and fuel prices and many counties sustained the pressure of such inflation without any glaring adjustment in interest rates. Therefore, the RBI may take into cognizance two aspects of the Indian economy that India is a transition economy and the present inflation, to a greater magnitude, is due to the global pressure on prices of food items and fuel.
Besides, greater coordination between monetary and fiscal authorities is needed as both are complementary to each other and not supplementary in character. It is generally accepted that CPI is a robust indicator of rise in price level as it is attributed with credibility and transparency of the monetary policy but at the same time it is to keep in view that developing economies are subject to exposure of numerous variables which are considered to be the volatile items and are kept out of the circumference of core inflation rate and these items are ignored while framing a monetary policy.
The RBI is recommended to frame an effective strategy for favoring a moderate inflation rate within the threshold magnitude and realistic economic growth under the prevalent global economic conditions and the desired economic growth that will create more employment, more income, more saving and consequently more capital formation . This impetus needs to be ensured so that the growth cycle is not interrupted. The economy needs a robust aggregate demand management strategy which is the need of the hour. Aggregate demand denotes the total spending of the nation as a whole and rise in interest rate will have adverse impact on the aggregate demand.
(The author is an Independent
Researcher and an Educationist)