How Rbi helped engineer Inflation.

With the inflation at 11% , both the ministry and the bad Rbi policy (which has been seen to clearly be in the governments good books instead of looking at hard facts) are to blame. Worse the RBI unlike the British BOE is very non transparent, and influenced by politics.

Ila Patnaik writes in her post Engineering Inflation

How do exchange rate changes get passed on to consumers? When the rupee appreciates, and rupee price of international commodities falls, sellers may first not pass on the benefit to the buyer. Instead, their profit margins would go up, say, as their raw materials might have become cheaper. However, if there is competition in the market, sooner or later, prices in the domestic market will come down.

On the other hand, when the rupee depreciates and say, raw materials get expensive then companies take a hit, their profit margins go down. If companies keep selling at the earlier prices, they will go out of business. This leads to an increase in domestic prices. The structure of the market will determine the speed and extent of the passthrough. The graph suggests that the effect works both ways, when the rupee strengthens and when it weakens.

It is not expected that there should be a one to one relationship between the exchange rate and prices. For example, even with the rupee appreciating, if there was an increase in global commodity prices, inflation is expected to move up. The recent episode of inflation has been more difficult because the effect of the increase in global commodity prices was exacerbated by the RBI’s preference for a weak rupee. The sharp increase in liquidity that resulted from RBI intervention further strengthened the pressure on prices.

In her latest post on who is paying for govt policy- What price people?

In the last two years, while there was an increase in liquidity in the system due to dollar purchases of RBI, this liquidity was sucked out by selling Monetary Stabilisation Scheme (MSS) bonds. Here, the costs of running the pegged exchange rate regime were placed upon the ministry of finance which has to pay interest on the MSS bonds. However, after October 2007, RBI stopped selling MSS bonds.

There is no free lunch. Someone has to pay for the dollar peg. As the finance minister, P. Chidambaram, correctly pointed out in his budget speech, the interest payment on MSS bonds in the budget constitutes a subsidy to exporters that is borne by the exchequer. By stopping MSS issuance and switching to CRR hikes, the cost of this subsidy was shifted from the government to banks and their users.

With a hike in CRR, banks have to hold a larger proportion of their deposits as cash with RBI. This means the interest earned by them on deposits goes down. The reduction in returns is borne either by banks or their customers. Either depositors get less interest income or borrowers pay higher interest rates. This cost, borne by banks and their customers, is the price of subsidising exporters.

RBI is non-transparent about its actions and about the rationale behind these actions. When MSS issuance was stopped, no announcement was made, nor was a rationale offered. With a lag of months, external observers are left trying to piece together the events from incomplete data. Today, there is no institutional framework in India that enables Parliament to question RBI and its policies. No one is going to answer the question as to who is responsible for the macroeconomic mismanagement that has led to slower growth and higher inflation.

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10 thoughts on “How Rbi helped engineer Inflation.

  1. The biggest problem with the inflation we are facing right now is that it is caused more by international factors/elements than by domestic ones. There is a limit to the measures RBI could have adopted to bring down such an inflation. Sure they can play around with the liquidity but that alone won’t help as the inflation has now hit a record 11 per cent!

  2. Prax, hope you have recovered from the virus.
    By the way, I noticed you are spending a lot of time writing posts nowadays. Good ones too.

  3. nita, thanks and yes im a lot better , a bit weak but the headache is almost gone thanks to the precautions and diet i mindfully followed

    balu this is where u go wrong according to me
    yes there are external factors but there are also strong internal factors that cannot be denied
    the fact that the rupee has mirrored the dollar to protect the exporter thus the rbi has been focussing on rupee dollar rate instead of inflation control as recommended by the Rajan committee report, when it actually should have done the reverse,and now it is a tad bit too late and shock therapy is required,
    and that the govt has given freebies in thousands of crores, and hardly increased oil prices in last 3 yrs all funding the spend on borrowed funds and foolhardy confidence that the economy was robust and fiis would keep pumping in the investment dollars is taking its toll

  4. the flip side of growth is inflation. people have more spare cash and demand is up. it is not just you and me. think of the multiplier effect of the National Employment Guarantee Scheme — people are now getting atleast a 100 days of paid employment. that is 100 days worth of money to spend. The economy as a whole is growing and inflation is a by product.

    but the greater worry is the down turn in the US economy. India seriously needs to look at other markets, and developing the internal market.

  5. True ,
    The nregs money helps in the arid and drought prone areas , but at what cost ?
    nregs is failing in many parts in north india due to slipages – there is massive corruption especially in chattisgad and orissa and places in up and bihar – though it is partially successful in kerala making labor shortages. a friend who came back worked with the survey by economist Jean Dreze on nregs told me about the corruption right from the bdo to the panchayat.
    yes more money in peoples hands and more m3 in the system, but the price of everything is doubling
    and inflation is just another tax and people dont have that much purchasing power after all to get the bang out of the buck…

    worse more inflation happens due to the dollar peg and the fuel import costs.

  6. not just that, its a bit too late and a lot more is needed, now some hard choices like interest rate hikes and further oil price hikes at the pump will have to be made

  7. The inflation genie aint going back in the bottle. We are heading towards either hyperinflation or the end of the bretton woods 2 system.

    the RBI should stop trying to meddle in the forex markets.it is shameful for this nontransparent organization to hold the country to ransom.Central planning of the RBI variety has never worked in any country anywhere anytime.

    If it is trying to “fight” inflation, the RBI is naive to not realise that it is CAUSING the inflation in the first place by manipulating the forex markets.
    Rise in commodity prices is just a consequence of the money printing by the Fed and diversion of agricultural resources in US towards ethanol production (ill advised and immoral)

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