RBI policy hike, inflation, the economic outlook and the common man

The India growth story seems to have hit a temporary stumbling owing to both global reasons (like oil prices) and the domestic overheating of the economy caused by a steady growth of about 9%. Of the several issues that are inviting RBI’s concern in the recent times, inflation occupies the top spot, given that this is the election year. The RBI has been maintaining a hawkish stance for a while now and the First Quarter Review of Annual Statement on Monetary Policy for the Year 2008-09 brought out today, is very much in those lines. Two of the key rates viz., the REPO and the CRR have been hiked which essentially would make money supply dearer and result in reduced spending and consequently reduce the demand side of the market allowing the supply side to catch up and thereby reduce inflation. I would make an attempt to write how this move is going to affect or benefit the common man.

First off, the hike is not sudden or unexpected. It has been happening over a period of time and this seems to be the culmination and the only difference being that it sends out a clear signal that the RBI is more concerned about inflation than about growth, in a scenario where signs of slow down are obvious and needs to be given a boost.

REPO or Repurchase agreement is a tool, which is used by the RBI to infuse liquidity into the system. It is the rate at which the central bank lends to other banks or buys the government securities from the market and thereby increases the cash flow in the system. Increasing this rate would mean that it would be costlier on the part of the banks to borrow money from the central bank. CRR is the Cash Reserve Ratio – that part of the total assets of a financial institution, which should be kept as liquid cash. Increasing this rate will mean that banks will have lesser money to lend.

When both these rates are hiked, it is obvious that liquidity would be squeezed. When there is lesser money in the system, consequently the interest rates on various loans like auto/housing/personal etc would be raised so as to keep the banks up and running. As the interest rates go up, it would discourage borrowing from banks leading to a decline in the spending. Consequently prices would slowly ease out and thus inflation would come down. In short a common man may have to drop those plans, which would require a loan to be taken from a bank, owing to high interest rates.

The problem with this approach is that if lending becomes costlier, it’s going to have an adverse effect on the small and medium enterprise (SME) segment. These are companies that borrow from the banks to purchase raw materials or to expand their units in order to take up a new order etc. As a result, their cost of production increases and if not accompanied by an increase in the selling price, they are heading for a lessening of their profit margins. If they decide to increase the prices, they might end up losing customers. The large corporates will also face a problem when it comes to borrowing to carry out their expansions. When expansions are halted, the potential job opportunities it could result in are also cut down. In short, growth will slow down.

It is important at this juncture to realize that growth has to be compromised a little to take on inflation, which would have disastrous effects. A slow down in growth will affect only a certain section of the people and not necessarily in an adverse manner but spiraling prices would hit the common man hard. Growth has to be more sustainable and inclusive to have more a greater impact. If we can reduce our excessive or conspicuous consumption a little for the sake of easing the pressure on the bare minimum survival needs of a society at large it isn’t a bad proposition. To that extent the moves of the RBI, though a little tough, are well thought off and proactive but it remains to be seen how soon the effects would set in as the inflation figures, in the present scenario, is also dependent on the external factors like the price of crude and the commodities on a global scale.


rahul said...

well RBI is now completely focussed on getting inflation down, this measure would really hit our growth(GPD), also the WPI index is a bit flawed coz the prices of food articles haven't risen much it is just the crude that is jacking up the inflation.

Prachi said...

very informative :)

suren said...

@rahul ... WPI is a bit flawed is ok dude.. but food has risen and i m seeing it myself ... how much inflation is a reason is a point of debate though crude is a major reason .. if not controlled, its a matter of time before inflation affects the next strata, the middle class

@prachi .. thanks.. visit for more information ;)