Inflation has risen in recent weeks. Higher food prices are the biggest contributor to this rise. The rise in inflation raises a question on the RBI’s stance on monetary policy. Should interest rates be raised in response to higher food prices? The weak monsoon is likely to push up further the prices of vegetables, pulses and rice. Should the RBI respond by tightening monetary policy? No amount of raising rates will bring vegetable prices down. Monetary policy, when effective, can impact prices and output four to six quarters later. The last thing to expect from it is an impact on seasonally volatile prices in specific sectors.

The mechanism through which interest rates impact prices is by changing demand. This happens over many months. Higher real interest rates compress demand. The transmission mechanism of monetary policy takes about one-and-a-half years in countries like the United Kingdom, which have well-developed financial markets. In other words, raising interest rates makes investment and consumption more expensive today. This reduces demand for goods and services over the quarters to come, and that leads to reduced pressure on prices.

The question we need to ask before prescribing a tighter monetary policy to control inflation is whether the Indian economy needs a further contraction in demand. Posed this way, the answer to this question is fairly obvious. Despite the incipient recovery seen in industrial production, the Indian economy continues to face a decline in demand. The last thing it needs is further demand contraction. Even if the world economy picks up and investment sentiment improves, it is likely that external demand (net exports) and private corporate investment will not recover fully in the coming four to six quarters to pre-crisis levels. Further, the weak monsoon will lead to a contraction in rural demand as incomes of farmers and agricultural labourers suffer due to a fall in production. In an economy in which demand has fallen sharply and would remain weak for the coming months, does a policy of further contracting demand through a hike in interest rate make any sense?

... contd.