Cut policy rates to reduce inflation: Basu

Basu pointed out that under equilibrium market conditions interest rate changes can lead to counter intuitive outcome. The Turkish Central Bank has been pursuing an unorthodox monetary policy by keeping interest rates low while increasing banks’ reserve requirements to cut loan growth and limit domestic demand.

There was a strong view in the same meeting that the RBI should have meted out a “shock treatment” by effecting sharp hikes in rates to douse inflationary expectations at the very beginning of the current monetary tightening stance. Those advocating this said high inflation has persisted because the ‘baby steps’ of small increases in policy rates have been ineffective in anchoring inflationary expectations.

The RBI has hiked policy rates a dozen times since mid-March 2010,but at every instance the increase has been limited to just 25-50 basis points. It last raised the repo rate (the rate at which banks borrow from the RBI) on September 16 by 25 basis points to 8.25 per cent. The wholesale price index-based inflation stood at 9.9 per cent in March 2010. It has continued to hover around the same levels through the last financial year and now stands at 9.78 per cent in August 2011.

The alternative view – that inflation has largely been of the cost-push variety – seems to suggest that these cannot be attributed to excess demand,and hence cannot be tackled through interest rate increases as has been conducted by the RBI to compress demand. Cost push inflation itself,according to the proponents of this view,is attributed to two factors: one,food price increases arising from demand-supply imbalances in agriculture and two,high global commodity prices including oil,metals. “High interest rates do not address this,” said an economist who was part of the deliberations.

Advocates of sharp rate hikes claimed that inflation was persisting due to a wage-price spiral driven by inflationary expectations. Critics of this view,however,pointed out that such shock treatment might indeed have killed inflation,but also simultaneously killed growth and triggered a problem of insolvency among debtors.