Inflation demands fiscal action more than a monetary one

News: Recently, Inflation in India has been on an upward path

Status of Inflation

Wholesale price index inflation stands at 15% and consumer price inflation is nearly at 8%.

About the monetary policy system in India

In 2015, India introduced the ‘channel system’, in contrast with the ‘floor system’ of the US.

The policy rate ranges between the upper bound rate at which banks can borrow from RBI under penalty and the lower bound rate (such as the marginal standing facility), at which banks can park their funds with RBI for a positive rate of return (referred to as the reverse repo rate).

Should RBI do another hike in its policy interest rate soon?

The RBI’s standing deposit facility (SDF) rate of 4.15% along with a repo rate hike to 4.4% counts can lead to double tightening of monetary policy.

At present, RBI has adopted the SDF rate at the place of the reverse repo rate. The SDF rate (4.15%) is well above the old 3.35% reverse repo rate. Overall, an SDF is beneficial as it does not require the collateral of government securities, while reverse repo transactions do. This will free up G-Secs for other collateralized borrowings, reducing the risk in such transactions significantly, etc.

An increase in the upper bound (repo rate) makes it costly for banks to have inadequate reserves.

Similarly, a decrease in the lower bound reduces their incentive to park money with RBI and increases liquidity in the banking system, affecting other short-term interest rates as banks go in search of adequate returns on now-surplus funds.

The RBI has raised the reverse repo rate from 4%, to 4.40%. The SDF rate was revised from 3.75% to 4.15%. This means monetary policy was tightened considerably in two ways.

Should monetary policy respond to supply shocks?

The current rise in inflation is primarily a result of oil price escalation on account of the Ukraine-Russia war. This inflation has rippled through all other commodity prices. It constitutes a supply shock.

If RBI raises its lending rate further, it may lead to another shock. For example, the working-capital loans and short-term credit lines to firms will become costlier.

Way Forward

Monetary Policy

The channel or corridor itself is also an effective policy tool. If the central bank wants to tighten monetary policy, instead of increasing its policy rate each time, the RBI can shift the corridor up.

The corridor changes alter the opportunity cost of funds kept with RBI. For example, if the corridor is shifted downwards, or if the lower-bound SDF rate is declined, banks won’t keep extra funds with RBI. They would invest elsewhere for returns. It will increase demand for short-term securities, thus raising their prices and lowering yields.

The corridor changes have better and more direct transmission than transmission of policy rate changes.

Fiscal Policy

The government can go for fiscal policy. For example, price relief on petroleum products through a reduction in taxes.

At present, the wholesale inflation has not translated directly into retail inflation so far. Therefore, the government should release stock to address food inflation.

The government can invest in cold chains for perishables. It can stabilize prices in the longer term and help India keep inflation in control.

Source: The post is based on an article “Inflation demands fiscal action more than a monetary one” published in Live Mint on 02^nd June 2022.