The Reserve Bank of India (RBI) has declared a war on inflation. Today the apex bank raised the key policy rate, the repo rate, by another 50 bps to 4.90%.
The increase in the repo rate comes in a period little over one month after the Reserve Bank in an off-cycle policy move on May 4 increased the rate by 40 bps.
During the peak Covid times, the RBI slashed the repo rate from 5.15% (pre-pandemic level) to 4% at different stages. Repo rate, over a period of time, has become a household term as its impact is directly on the domestic budgets.
The movement in this policy rate decides the cost of loans (in terms of rate of interest) for the retail borrowers. As the rates stand upward by 90bps, expected to cross the pre-pandemic level by August this year, will make popular retail loans like housing loans, car loans, personal consumption loans, business loans etc. more expensive.
The EMIs of the existing borrowers will go up and they will have to shell out more to fall in line with the revised rate of interest. The impact will be equally on the new borrowers as the cost of loan will shoot up.
These back-to-back repo rate hikes in a span of little over one month, the RBI has started showing its focus entirely on the management of inflation, which is the most worrying situation as prices of essential as well as non-essential commodities are spiraling out of hand.
Notably, core inflation has already breached the Reserve Bank’s targeted range of 2%-6%. Currently, it stands at 7.7%.
Generally, common understanding about inflation is that it occurs when there is more demand than availability of the supply. And this gap in demand-supply leads to price rise.
However, there are abnormal factors too that trigger inflation to higher levels. In such abnormal situations, controlling the inflation and bringing it to acceptable levels is a real challenge to the central bank of any country.
Since 2020 we have faced (and continue to face) two unprecedented abnormalities in Covid-19 pandemic and the Russia-Ukraine war. Both have wreaked havoc with the global economy, leaving apart the destruction caused on the health front where millions of lives were lost.
First it was the pandemic which not only broke global economic chains but also forced economic lockdowns across the global geographies. Millions lost their jobs and millions faced drastic cut in their household incomes.
Secondly, the outbreak of the Russia-Ukraine war at a time when the global economy was in recovery mode, derailed the momentum and fuelled the inflation in the danger zone.
The run of the mill approach to tame this kind of inflation has proved a futile exercise and wastage of resources and time. This forced the central banks to print money in a bid to trigger economic recovery which was badly hurt by pandemic-induced lockdown. Lowering the policy rates, such as the repo rate, was used as another arsenal to tame the rising inflation.
Reports reveal that in peak Covid times, when the economy was in shambles, central banks printed record amounts of money, which led to the amount of money chasing a small number of goods increasing. In this scenario, the prices of essentials as well as non-essentials witnessed an upward trend.
The concept of printing the currency is basically an act of toying with the idea of helicopter money – a reference to an idea made popular by the American economist Milton Friedman in 1969. It is an unorthodox monetary policy tool option that is used by central banks to stimulate economies. Here the basic principle is to increase broader economic activity and push the inflation up by putting more money in circulation in the market.
As printing of money to finance the deficit increases inflation and is believed to be an attempt to extract more output in an underperforming economy, it is potentially loaded with huge risks. Historically speaking, we don’t find a sterling history whenever the governments have printed money to finance their deficits.
One of the primary risks associated with helicopter money is that the policy may lead to a significant currency devaluation in the international foreign exchange markets. The currency devaluation would be primarily attributed to the creation of more money.
Notably, there were very vocal voices here in the government circles during peak Covid time who were calling for printing money to fund the deficit.
Meanwhile, the ongoing Russia-Ukraine war has created a commodity crisis. Obviously, the situation is ripe for price rise.
In fact the stage is set for inflation to ripple through the economy and cause more pain in coming times. If we look at the higher interest rate scenario, we see growth taking a pause as there will be slowness in the economy.
To conclude, the rise in rate of interest in retail loans such as home loans, car loans, consumption loans etc is not a major worry for borrowers. The major setback to their domestic budgets has been the never-seen-before spiraling prices of essentials and non-essential commodities.
Now, the war on inflation cannot be overlooked as it has been already delayed. Meanwhile, one important question continues to linger on: Is the current level of inflation in the country because of helicopter money?