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  • Nov 01, 2022
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How RBI fell behind the curve on containing inflation

Why in News?

Very soon, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will convene to formulate its response to the Government of India about the high rate of inflation in the country.

What is inflation?

The general rise in the price level of goods and services is called inflation. The Reserve Bank of India is the authority to control inflation under RBI Act 1934.

Inflation targeting by RBI: The RBI is by law responsible for maintaining price stability.

  • Under the “inflation-targeting” regime that began in 2016, RBI has to retain the inflation target of 4%, with a tolerance band of +/- 2 percentage
    • Thus, for any given month, RBI’s comfort zone for inflation lies between 2 percent and 6 percent.
  • Under the RBI Act, 1934, if the central bank fails to meet the inflation target for three consecutive quarters, it is required to provide the following information to the government:
    • reasons for the failure to achieve the inflation target;
    • remedial actions proposed to be taken; and
    • an estimate of the period within which the inflation target shall be achieved pursuant to the timely implementation of the proposed remedial actions.

How does the MPC target inflation?

Composition of MPC: The MPC has six members including the RBI Governor — three each nominated by the RBI and the government, who meet every two months (starting from February every year).

What is the repo rate and How does movement in the repo-rate influence inflation?

Repo rate; – (it is the rate at which RBI lends money to commercial banks).

  • For instance, at times of high inflation RBI increases the repo rate (“dear money policy”) which results in costlier borrowing both for consumers and producers and effectively slows down economic activity in the economy.

How did RBI fail to check inflation?

  • Time lag: MPC’s knowledge of inflation typically lags by two months — which means as it deliberates in October, it works with data until August.
  • Accommodative stance of RBI (growth more priority than inflation control): RBI despite being aware of the inflation level has kept the repo rate unchanged at 4 percent and to continue with an accommodative stance as long as necessary to revive and sustain growth on a durable basis.

Limitation of monetary policy in curbing inflation

  • Incomplete transmission; – it means that the cumulative easing in policy rates by RBI is not being reflected in the lowering of their lending rates by banks.
  • Policy rates are not market linked; – the repo rates decided by monetary policy committees are not truly market linked which results in banks many times negating these policy rates set by RBI.
  • Cost-push inflation; – due to disruption in the supply chain of the produce e.g. Russian-Ukraine war.
  • Ineffective against supply shocks; – RBI’s policies can stabilize inflation only caused due to demand shocks and they are ineffective against supply shocks.
    • For instance, food inflation is prone to supply-side bottlenecks and is out of the scope of any remedy under the aegis of the monetary policy of RBI.
  • Limited financial inclusion; – India suffers from limited financial inclusion. Indians, unlike Americans, earn before spending and do not live by credit. This limits the success of RBI’s credit control policy.
  • Fiscal policy; – The Central and State Governments can play a progressively active role to help curb inflation by framing new policies or altering the old ones.
    • Many times there is no synchronization between monetary and fiscal policy.
  • Globalisation; –
    • With the current uncertainty about the global economy, especially in the United States of America and the Eurozone due to the Russia –Ukraine war, RBI should not rely on monetary tools alone to combat inflation.

Functions of RBI

Mains:

  1. What is inflation targeting? From a critical assessment of inflation-targeting by the Reserve Bank of India (RBI) in the Indian economy.

Prelims:

  1. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (UPSC CSE 2020)
    1. Cut and optimize the Statutory Liquidity Ratio
    2. Increase the Marginal Standing Facility Rate
    3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below :

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

Ans: (b)