The RBI vs. Inflation - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 1 February 2014
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- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
Earlier this week, the Reserve Bank of India (RBI) increased the repo rate by 25 basis points up to 8%. Once again, they have taken markets by surprise, as rates were expected to remain unchanged. The new RBI governor Raghuram Rajan has increase interest rates for the third time since taking office 4 months ago.

The increase in interest rates comes against a backdrop of increasing risk aversion in markets, and falling currency values in emerging markets. The Indian rupee rose following the rate increase, and has generally been stable in recent months. The big issue for the Indian economy remains its low growth rate. Annual growth currently stands at just below 5%, well off its highs above 9% in 2010.

The RBI's recent actions indicate that their current priority is to fight inflation. And their tool to do so is increasing interest rates. This is in stark contrast to many countries like the US or Eurozone or UK, that have primarily been lowering interest rates in an effort to boost growth.

The RBI governor has made it clear that the best way to boost growth is to lower inflation. In a recent interview he explained that there is no tradeoff when it comes to growth and inflation. When the RBI pursues monetary policy to bring down inflation, this isn't going to bring down growth at the same time. Or even if it does, it will only be short term. The short term cost to growth is worthwhile, because growth will improve in the medium to long term when inflation rates are lower.

There is much criticism on this policy, in particular from businesses that suffer due to rising borrowing costs. They have long been calling for interest rates to be brought down to boost growth, but this has yet to happen.

One of the arguments put forth is that much of India's inflation (e.g. food price inflation) isn't a result of interest rates that are too low, or too much liquidity in the system. Food price inflation is instead a result of bottlenecks in the supply chain and a high dependence on rainfall. If this is the case, it is difficult to see how higher interest rates will reduce food price inflation.

The RBI has made its priorities clear. Their goal is to do what they can to fight inflation, as inflation is the biggest problem facing the Indian economy. Over the course of the next year, we will see how successful this approach is, both in terms of reducing inflation, and improving medium term growth.

We invite you to please post your view on the Equitymaster forum. We are asking the question: Should the RBI keep raising interest rates to fight inflation?

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is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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7 Responses to "The RBI vs. Inflation"

Alphones

Feb 3, 2014

Dear Assad,In my opinion, the inflation will remain as you are predicting. As you wrote in your article above, supply and rainfall. Even the rainfall cannot do away the trick. There shall be a low demand, which can be achieved only by controling the population growth.
Oil import is the killer disease for India.
Indian currency is becoming like Zimbawe currency.

Like 

Subhash Parab

Feb 2, 2014

It is ridiculous how RBI is going to change inflation with the rising rate of interest. Rising rate of interest is not only pinching the industries but also to individuals who borrow from the banks/market. You have rightly pointed out the same.

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Prasad Rao Sirani

Feb 2, 2014

No. The prices can be controlled if the Government is firm on producers raising the prices at their whims and fancies in greed of more profit. Are the prevelant prices on various goods reasonable taking into account the purchasing power of the public? Banks should take severe steps on wilful loan defaulters which will help reduce bad debts.

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BRIJ Singh

Feb 2, 2014

Increase in interest rate will attract more people towards saving in banks as FDR and thus money supply will decrease in the market thus reducing consumption and in turn inflation. The money supply has increased due to pay rise of BABUS and govt servants after pay commission. In my opinion two steps of the govt are responsible for the fall of rupees against dollar. Govt decision on Vodafone case and high expenditure of govt.

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Vijay

Feb 2, 2014

Everyone is fooling the others in India. RBI too has joined in. RBI governor is like that doctor who is just and MRP and is prescribing a dose, repeatedly over and over again to a patient, whose disease does not get cured but with each dose keeps on persisting/ increasing. It only shows that they all are not only incapable/inefficient/good at fooling/ but are also clueless as to what to do. God bless this great nation where masses are being subjected to steeling of their pockets by the government agencies.

Like (1)

Prafulla Dangat

Feb 2, 2014

Yes..Indeed. Raising Interest Rates to tackle Inflation is the (only) way...for Inflation is always necessarily a Monetary Phenomenon...For India, it is more so evident, due to increase in money supply as evident in large fiscal deficit & unproductive welfare schemes...

Like (1)

vijoy

Feb 2, 2014

Everyone is fooling the people that inflation is due to poor rainfall. The rainfall has been constantly varying between 5 %+ r - every year.The RBI governor has clearly said that the 1 lac + crore bank loans to the corporate is not being paid back. The main reason is that most of it is already in the pockets of politicians who coaxed the banks to grant those technically unworthy loans. The inflation took an exponential rise just after the elections in 2009 & in spite of the false promises of the government on the floor of the parliament that inflation would be controlled within reasonable limits. It never happened and the corporate had a free access to the public money through banks.Othewrwise how does one account for frequent power tariff rates being hiked in the states and the milk prices being hiked by almost 2% every two months or the Diesel price ,being regularly hiked. There is no mechanism to resort to cost auditing in any sector. Anyone is charging profits ranging from 30 % to any level beyond 200-300% in the age of liberalization.These are the real reasons for inflation.

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