The RBI's Inflation Dilemma - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 9 June 2012
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- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
As economic growth falls, the Reserve Bank of India (RBI) once again faces a decision whether to cut interest rates to spur growth. This would be an easy decision were it not for the fact that inflation has been consistently rising since the start of the year. This is a difficult decision because of the trade offs involved. Cut interest rates to boost growth at the risk that inflation balloons. Or leave interest rates the same and risk that growth continues to tumble.

Our assumption with that line of thinking is that inflation is significantly affected by the RBI's interest rate decisions. However, if we look at the causes of inflation, we'd see that most of it is completely out of the RBI's control. And actually, the RBI's decisions will have little impact on inflation.

India's inflation is generally caused by two factors. The first is food prices. If there is a bad monsoon and a poor crop, food prices will skyrocket, people will blame the government, and we'll continue to discuss why we leave ourselves so vulnerable to such events. This is an important factor, but not the one that is causing our inflation today.

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Today's inflation is driven by something else. It is driven by the rupee depreciation. The rupee has fallen around 20% this year, and this has made our imported goods more expensive. Most importantly, the price of crude oil has been rising in rupee terms. Even though there has been a recent fall in the past few weeks, crude oil prices have been sky high through most of this year. As the rupee has depreciated, crude oil has become more and more expensive, and this is causing higher inflation.

It is not just crude oil. Anything and everything that we import is going up in price due to the rupee depreciation. What's more, there is little the RBI can do about it. The price of crude oil and other imported goods is largely beyond our control. The depreciation of the rupee is the result of falling growth and global risk aversion.

Back to where we started, the dilemma facing the RBI. Except that it is not a dilemma any more. If the RBI lowers interest rates, it will not have any significant impact on inflation. This is because inflation is not caused by the RBI's interest rate changes. Thus, the right strategy for the RBI is to lower interest rates to boost growth. A boost to growth may even push the rupee higher due to improved sentiment, and this would help us with the inflation problem.

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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8 Responses to "The RBI's Inflation Dilemma"

AJ

Jun 12, 2012

Is the rupee depreciation is fueled by the Government itself. With Government revenues moving south and economy slowing down and no other avenues to raise funds, then make some policy change so that you have flight of foreign capital and dollar becomes dearer. With petroleum prices also going down where will the Government get their revenues to fund the populist programs to bloster their chances from being totally wiped in the next election. Our politicians just need scape goats and RBI is now have to take its turn. Especially after Pranabda has taken as FM things are not in the right perspective, especially the Vodafone case, were the revenue lost the case in SC.

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R V Iyengar

Jun 10, 2012

Yes your opinion seems sensible.
As a matter of fact the repeated hike of rates all round by RBI did not give any results. Only when the economic situation changed the inflation started inching lower. Again it is holding steady or going up as IR started to depreciate vis-a-vis the dollar.
Hence the right thing would be to take the bold step and plump for better rates to aid the industry.
However we don't know if Govt will allow it to do so.
After all, the allies are shouting hoarse against it and survival of Govt is held at stake.

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Kuldeep Nayar

Jun 10, 2012

Mr. Dossani, you may well be right, but I firmly believe that this is the wrong moment for RBI to cut rates. In my layman's opinion, RBI should allow the rupee to depreciate. This will help boost exports (and as it is export oriented industries enjoy a better rate of interest) which are desperately needed to boost industrial activity. Local consumption will steadily decrease if inflation is allowed to run unchecked. If we need to import, exports must be the primary concern. There are other factors that also get impacted negatively if rate cuts take place. Rate cuts must be preceded by current account imbalance repair and Government's fiscal deficit reduction. Do not look only at the stock market. Please understand that the decades of populist measures are to be set right now before it is too late. As they say 'the chickens are coming home to roost!'.

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Harmohan Kawatra

Jun 10, 2012

Yours is a simplistic view.
Another simlistic is reverse, as per my thinking, international factors apart, inflation has contributed more to rupee devaluation than other way round.
Taxation policy and heavy subsidies, not resulting in production is another main cause of inflatopn. I donot thimk RBI can do much about inflation, when Government policies are faulty.

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Krupa David

Jun 10, 2012

The RBI Governor is not a fool.There are too many counter forces working on him and thus he is unable to take a rational economic decision.With thousands of tons of food grains,vegetables and fruit rotting,it is a no brainer that the supply side needs to be tackled.Strengthen the Rupee and inflation will ease.

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E Vishwa Nathan

Jun 10, 2012

Dead right. There is no correlation between interest rate and foodinfltion, which is basically due to supply side constraints. By addressing the supply side constraints on food articles, the interest rates can very well be reduced to stimulate the economy.

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R Gopalan

Jun 10, 2012

I agree with the above perception on interest rate. Since controlling inflation through interest rates has limited effect, RBI should go in for 50 bp cut in the meeting on 17th June. Such a move shall at least boost the growth sentiment, including upping the rupee value as well as propping up the equity markets in the short term.

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athmanathan

Jun 10, 2012

Kindly forward this post to the RBI Governor and the president-aspirant Pranav Mukherjee to enlighten them.
Anyway what will happen will happen and the foolhardy
politicians will take the economy to its abysmal depths
without doubt.

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