The Trilemma Of The RBI (Impotant Article )

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Rajeev Jayaswal

The Reserve Bank of India (RBI) has raised its policy rate for the first time in about four years. The move will eventually prompt lenders to hike interest rates. The common man will have to bear the brunt of increased EMIs for purchasing property or car. Interestingly, pre-empting the move, some banks had raised their benchmark rates last week and others will follow suit. This is because the RBI has raised by 0.25 per cent the repo rate — the rate at which it lends money to commercial banks.

The RBI's decision would also make capital costly for the corporates, squeezing margins on their investments. Investors, particularly in the private sector, would be forced to revisit their investment plans. Fresh investment proposals could be scaled down or postponed, impacting the growth prospects of economy. A higher interest rate would also hit badly the exporters, who have already been facing difficulties due to high input costs and geopolitical challenges.

Why did the RBI take a decision that would hurt both the economy as well as the consumer? The answer lies in the mandate the central bank has. The prime objective of the RBI's monetary policy is to maintain "price stability". The job of the central bank is to shield millions of poor Indians from a spike in the prices of food, fuel and other consumables. The bank, therefore, maintains that the "price stability is a necessary precondition to sustainable growth."

The RBI uses several instruments, including the repo rate and the reverse repo rate, to manage money supply in the economy to check inflation.

The bimonthly monetary policy of the RBI is a tightrope walk. It is essentially a trilemma where the Monetary Policy Committee (MPC) has to juggle with three key elements — inflation, growth and currency. Apparently, in the present circumstances, all the three are incongruous. Inflation is going north; the economy is yet make a complete recovery of 8.2 per cent (the level before demonetisation) and the rupee has significantly weakened against the dollar.

Most of the economic analysts and market enthusiasts were in favour of the RBI maintaining a status quo and giving a chance to growth for two more months. They were fully aware that the constantly rising inflation that had surpassed the 4 per cent comfort zone was a cause of worry, but they had hoped that the RBI would wait and see the impact of an expected good monsoon before tinkering with the interest rate as inflation was nowhere around the alarming level.

Instead of taking the risk and raising the repo rate in August, the RBI decided to rein in inflation without further delay. One of its biggest worries seems to be the high import cost of crude oil. "Crude oil prices rose sharply till May 24 on heightened geopolitical tensions," the RBI statement said after the MPC meeting on Wednesday. Although crude oil prices have softened and the US has advised the Organisation of Petroleum Exporting Countries (OPEC) to raise supply, the rates are still high for a country like India, which imports more than 80 per cent of the crude oil it processes.

A sharp rise in retail inflation that had risen sharply to 4.6 per cent in April has been the major cause of worry for the RBI. Even after excluding the estimated impact of an increase in house rent allowance for central government employees, headline inflation was at 4.2 per cent in April, up from 3.9 per cent in March. The food inflation was, however, moderate for the fourth successive month because of low prices of vegetables, pulses and sugar. But the rising prices of other food items such as cereals, fruits, readymade meals, meat and fish were a matter of concern. It appeared that the RBI decision is also based on its own survey conducted last month that showed "a significant rise in households' inflation expectations."

The RBI has tried to justify the rate hike by citing examples of other Asian economies. While China, the Philippines and Indonesia have recently raised their benchmark rates, the US Fed is expected to hike the interest rate in its next policy meeting.

The rate hike would slow economic growth. Even details provided by the central bank show that the state of the economy is not in good shape and it is facing some serious headwinds. While a seven-quarter high growth rate of 7.7 per cent in January-March 2018 indicates that the economic recovery is taking place, this growth should be seen in the context of a low base effect of 6.1 per cent for the corresponding quarter of the preceding fiscal year.

The RBI has increased the policy rate and kept the stance "neutral". This is a sign of hope as well as despair. The devil is in the detail, which will be decoded only after the RBI publishes the minutes of the MPC on June 20.