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Dilemma of Monetary Policy

  • IASbaba
  • September 15, 2021
  • 0
UPSC Articles
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ECONOMY/ GOVERNANCE

  • GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment. 

Dilemma of Monetary Policy

Context: In the monetary policy resolution announced on August 6, 2021, the Monetary Policy Committee (MPC) decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 4 per cent.

What is the dilemma of MPC?

  • The repo rate reverse repo rate and the marginal standing facility (MSF) rate are all kept unchanged. RBI has also decided to continue with the accommodative monetary policy stance till the economy recovers from the shock of the Covid-19 pandemic.
  • However, there was some divergence of opinion among the MPC members who argued against the accommodative stance of the MPC because the projected inflation is beyond the target inflation rate (2%-6%).
  • This also led to comments as to whether the RBI has deviated from its mandate of flexible inflation targeting (FIT) and started emphasising growth over inflation.
  • Admittedly, the task of the central bank is to routinely do this tightrope walk, balancing growth and inflation (the dilemma). Depending upon whether inflation is triggered by demand-pull or cost-push factors, an appropriate decision is taken.

What are the cost-push factors for Inflation?

  • There are reasons to believe that the inflation faced by India currently is more of a supply-side problem. Due to long and uneven lockdown, the supply chains of the country have got negatively affected. 
  • At the same time, due to several reasons, international commodity prices are going up. This is seen in high prices of fuels, including crude oil and coal, metals like copper, aluminium and steel, cotton and other industrial inputs. Global container and semiconductor shortages are also adding to the problems.
  • An uneven and deficient monsoon may also add to this price pressure of food products. 
  • The combination of all these factors has led to increase in the prices of goods & services. 

Is there a demand-pull inflation?

  • Though the industrial production has shown a remarkable rate of growth on a year-on-year basis, but it was still 13.9 per cent below its May 2019 level. 
  • The RBI OBICUS survey of the manufacturing sector also indicates that the aggregate capacity utilisation is still below 70 per cent in Q4:2020-21. 
  • The latest quarterly GDP statistics shows that in real terms, many industrial and services sub-sectors have not yet reached the pre-Covid production levels.
  • All the above shows that it is unlikely that there is a demand pressure on the economy. 
  • If there was demand-pull inflation, then it needs to be suppressed using higher interest rates. This is currently not the case in India, hence no need for rate hike.

Conclusion

  • When inflation originates from the supply side, it will be very difficult to contain it by pushing up the rate of interest. In fact, if the interest rate is raised, then cost of borrowing goes up which may lead to further price rise.
  • Since the argument for demand-pull inflation is weak, the RBI’s decision to keep the interest rate unchanged so as to boost growth seems to be the right decision.

Connecting the dots:

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