Challenges and debates around the RBI’s approach to controlling inflation

Source: The post challenges and debates around the RBI’s approach to controlling inflation has been created, based on the article “Tweaking the inflation targeting mandate” published in “Business standard” on 21st May 2024.

UPSC Syllabus Topic: GS Paper 3 – Indian economy – Mobilization of resources

Context: The article discusses the challenges and debates around the Reserve Bank of India’s (RBI) approach to controlling inflation through its interest rate policy. It examines the effectiveness of the current inflation-targeting framework and suggests reconsidering the targeted indices and their calculations.

For detailed information on Concerns related to India’s interest rates read this article here

What is the current status of interest rates in India?

In 2020-21 and 2021-22, the Reserve Bank of India (RBI) kept interest rates low.

However, by mid-2021, inflation started rising, which the RBI initially ignored, labeling it transitory.

Then, in May 2022, the RBI dramatically increased the repo rate from 4% to 6.5% by February 2023 and has maintained that level since.

What are the issues with high interest rates?

High real interest rates are currently seen as too restrictive for economic growth.

Experts argue that these rates discourage new investments, which is vital for sustaining economic momentum.

There is speculation in the market about when the RBI will reduce these rates, indicating widespread concern about their impact.

The debate focuses on whether the high rates have already achieved their purpose of controlling inflation and whether it is time for a reduction.

What are the challenges faced by RBI in controlling inflation through its interest rate policy?

1. The RBI’s strict mandate to target CPI inflation at 4% +/- 2% limits its flexibility to adjust to other inflation measures or economic nuances.
2. External factors, such as US Federal Reserve policies, also constrain the RBI’s decisions due to the global influence on the Indian economy, especially considering the dollar’s dominance in international trade and finance.

What should be done?

Reducing Interest Rates: The RBI should consider reducing interest rates as the current high rates may have already achieved their purpose of controlling inflation.

Re-evaluating the Inflation-Targeting Framework: There should be a reevaluation of the inflation-targeting framework, particularly examining the effectiveness of the CPI as the sole index. Other indices like the Wholesale Price Index (WPI) and GDP deflator could provide additional insights.

Improving Transparency and Accountability: Transparency should be improved regarding the RBI’s decision-making processes and the factors influencing these decisions, especially concerning any reports submitted on failing to meet inflation targets, to foster greater accountability and public trust.

Question for practice:

What factors are influencing the debate surrounding the Reserve Bank of India’s (RBI) approach to controlling inflation through its interest rate policy?