There has been demand to lower the interest rates since the inflation slipped to 1.54%.
Economists, however, suggest that the monetary policy should not formulated based upon inflation.
How is inflation understood in India?
India opted for the Monetary Policy Committee to deal with inflation targeting.
This has led to an idea that the central bank will now be judged entirely in terms of its record on inflation.
The model underlying inflation targeting is that inflation reflects output being greater than the economy’s ‘potential’. This is called the output gap model.
The proposed demand now is to bring output back to its potential level via an interest rate hike.
How is it a flawed model?
The problem with this model is that the potential level of output is unobservable, uncertain and is highly variable.
This flaw is evident given the agriculture sector of India, where production fluctuates to a large extent with subsequent fluctuation in prices.
Now, when the relative price of agricultural goods rises due to slower growth of agriculture, the inflation rate rises.
Such an inflation has nothing to with an economy-wide imbalance gap as visualised in the ‘output gap model’ underlying inflation targeting.
With this perception, the slow growth in other sector of economy, manufacturing, is going unnoticed.
Rising interest rate as a response to rising agricultural prices would only be at the cost of output loss in the non-agricultural sector.
The drawback with new arrangement is that RBI cannot be held responsible for what happens to growth as it is to be judged entirely by what happens to inflation.
What is the way out?
Developing countries such as India have an economic structure different from the developed ones of the West for which inflation targeting was first devised.
Inflation targeting should be based on a proper understanding of inflation in the Indian context.
It is to be recognised that even though the RBI cannot directly move agricultural prices, its response to their movement matters.
RBI and the MPC have to acknowledge that they have erred in taking real rates in India to the highest level in 16 years.
As agricultural price inflation continues to fall, driving down the overall inflation rate, the real rate of interest rises.
If the central bank does not respond by lowering the policy rate, the real rate of interest will continue to rise, with negative consequences for non-agricultural output.
