Many people are bewildered, wondering what is hurting them more, inflation or interest rate hikes, which are meant to address the problem of inflation. While inflation may be relatively high at 6.5 per cent, it does not yet appear to be runaway and completely out of control. In contrast, monetary policy, with call money rates going above 70 per cent, seems to have been lost control of. Neither is the policy able to provide stable conditions in financial markets, nor is it able to control inflation.

Why has this situation arisen? Money gets created in two ways. First, when the RBI buys a dollar with rupees, it creates rupees. Second, when the RBI lends to the government, it creates rupees. For many years now rupees have been added to the existing stock of money circulating in the economy mainly through dollar purchases of the RBI. Indeed, dollar purchases have put so much money into the economy that the RBI has sold government bonds to banks to suck rupees out from the system. When banks buy government bonds from the RBI, the rupees that entered the economy through its intervention in the foreign exchange market leave the system. The impact of the forex intervention is thus ‘sterilised’. Sterilised intervention is sometimes used by central banks to stabilise conditions in the market. It rarely works as a long-term policy.

Today sterilised intervention is hitting its limits. If the RBI had been able to fully sterilise its foreign exchange market operations, it would have been able to reduce the high growth of credit in the economy gently over the last few years. In the last three years bank credit has been growing at 30 per cent. The RBI talks of a 20 per cent growth in credit as one that would sustain demand at a level at which inflation would remain between 5 and 5.5 per cent. The policy has not worked, because banks have been reducing their holding of government bonds and giving out loans instead. Since the economy has been booming there has been enough demand for loans. With low appetite for government bonds, the rate of money and credit growth coming from the RBI’s rupee manipulation exceeds the contraction through sterilisation.

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