Inflation Over Growth

This post has been authored by Indu Dahiya, the Research Analyst Intern at Arthashastra Intelligence

The trade-off

Economists believe in a positive trade-off between inflation and economic growth. Thus, high growth can be obtained at the cost of high inflation. When the pandemic started both RBI and GOI adopted growth-friendly policies as businesses were in the danger of shutting down due to lockdown and an exponential increase in infection cases and later death cases. Demand dropped drastically followed by supply-side disruptions in the global market, reduced productivity and a surge in Fuel price which increased the price of commodities around the globe. The USA saw the highest inflation in 40 years. Central banks all around the world started taking expansionary monetary policy and dropped their interest rates. Once the impact of corona started fading in 2021, they started tightening their monetary policy, to absorb all the excess money in the system. But India kept its rates stable from May 2020 MPC meeting till the end of February 2022, prioritising growth over inflation. This concerned many people as both CPI and WPI inflation grew over the target inflation rate. But it is believed that inflation is a temporary problem. Recently, due to the Ukraine crisis and sanctions in Russia, we are expected to face more problems, in terms of fuel(more than $100 a barrel), a rise in prices of edible oil, wheat and animal feed which in turn spiked the prices of poultry, eggs and dairy products. The CPI for January and February 2022 spiked more than 6% (tolerance level)

Finally, RBI shifted its focus from growth to inflation on Friday.

How it works

The interest rate at which the RBI charges from commercial banks when they borrow from it is the repo rate. On the contrary, the interest rate the RBI charges commercial banks when they want to keep their excess funds with the central bank is called the reverse repo rate. During the time of corona, the MPC cut both the repo rate and the reverse repo rate. This means that the banks could both lend and deposit money at lower interest rates. This was done to provide liquidity to the suffering businesses and to increase private consumption. Now, this created excess liquidity in the market.

Today, the repo rate stands at 4% while the reverse repo rate is 3.35%. But along with these tools, RBI introduced the Standing Deposit Facility (SDF) on April 8th. What is SDF why do we need a new liquidity instrument when we already have these two?

When the commercial banks deposit their funds with the RBI, they are given securities in exchange, which work as collateral. But it is running out of securities now and thus they introduced this new instrument to offer without collateral. But why would commercial banks deposit their funds without collateral? Because they’ll be given a higher interest rate in exchange (3.75%). One more question arises here, why is RBI running out of securities? Because of excess liquidity in the system, the reason which we saw above.

The Future ahead

This is the first step toward extracting excess money from the market and This is the first time in three years that the central bank has prioritised inflation over growth. The key rates are kept unchanged (the reverse repo rate at 3.35% and the repo rate at 4%) and the focus is on inflation. The inflation projection for FY23 hiked from 4.5% to 5.7% and the growth rate from 7.8% to 7.2%. RBI is expected to take more measures like this in the near future. Let’s see what the future holds.