The double-barrelled attack on Inflation is more posturing than good economic policy. In the last four years, preventing rupee appreciation and risking high inflation was a policy choice made by the Government and RBI. Today’s inflation is the natural consequence of this political choice. Fire-fighting inflation with sharp hikes in interest rates will now do more harm than good. What is needed is long-term reform.
We have seen this movie before. In the mid-’90s, RBI fought a grim battle to prevent the rupee from appreciating in an attempt to subsidise exporters. From March 1993 to September, the exchange rage was kept between Rs 31 and Rs 32 to the dollar. Over this period, RBI added $12.6 billion to its reserves in its effort to prevent the rupee from appreciating. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 20 per cent per annum. Not surprisingly, inflation took off. Interest rates were used to combat inflation. The 91-day rate went all the way up to 13 per cent by November 1995 in this fight against inflation. RBI won this fight. But many people believe that this increase in interest rates led to the souring of a remarkable phase of high GDP growth.
Now we have a second edition of the same story. Once again, currency pegging has perverted domestic monetary policy, and ignited inflation. RBI fought a grim battle to prevent the rupee from appreciating in an attempt to subsidise exporters. After three years of high liquidity growth, even after early 2007 when the first signs of inflation started appearing, RBI added $110 billion to reserves in its effort to prevent rupee appreciation. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 31 per cent. With a huge stock of liquidity in the system, a shock in global commodity prices ignited high inflation in the domestic economy. RBI’s monumental mistake was then to engineer a rupee depreciation that pushed up prices even further. It then stood by passively and watched as the rupee depreciated and prices spiralled.
The first and most obvious question to ask in this story is about RBI’s focus on inflation: why does RBI not learn from history? Why does RBI obsess with currency pegging, even though it has led to such costly distortions of monetary policy? Why is subsidising exporters more...
