Reducing inflation without raising interest rates

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It is unfortunate that many see monetary policy and interest rate policy as synonyms. They are not

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The target inflation rate is 4 per cent in India. So, the recent Consumer Price Index-based inflation rate at 6.4 per cent is 2.4 percentage points, or 60 per cent (2.4/4 x 100) higher than the target rate. Even the core inflation is somewhat stubborn at close to 6 per cent. And yet, the Reserve Bank of India (RBI) did not raise the repo rate in its meeting on April 6. Why?

A rise in the repo rate could have hurt not only economic growth but could have also lowered bond prices. A fall in bond prices can affect assets of banks — notwithstanding the accounting norms. And, banking stability has become important in the light of the tragedy at Silicon Valley Bank in the US and Credit Suisse in Europe in recent weeks. There is now some concern in India as well, though this is often not explicitly stated.

The question is: Can we have an alternative policy that can fight inflation with fewer side effects? The answer is, yes. 

The alternative policy proposed here is in three parts. First, the RBI should adequately but temporarily increase the statutory liquidity ratio (SLR); at present, banks in India are required to keep at least 18 per cent of their deposits as approved securities (read, government bonds), though they often hold these in excess. Second, the RBI should slow down the growth rate of its money and relatedly buy less of additional government bonds. Third, the RBI should keep the repo rate unchanged.

The three proposed policies are consistent. The rise in SLR generates additional demand for bonds by the banks even as the RBI slows down the purchases of bonds. Given the rise in demand by banks and the fall in demand for additional bonds by the RBI, there will be hardly any effect on bond prices and relatedly on the interest rates. This is consistent with the other proposed policy that the RBI does not raise the repo rate.

If the SLR is raised, the lending by banks tends to fall. This reduces aggregate spending in the economy. This, in turn, reduces the inflation rate. It is true that the reduced spending can adversely affect economic growth, but given that interest rates do not rise under the proposed policies, bond prices do not fall, and so at least banking stability is, ceteris paribus, ensured. It is also comforting in the fight against inflation that the growth of central bank money is kept in check under the proposed policies.

An important role is played by the temporary rise in the SLR under the proposed policies. This raises the next question. When can the RBI withdraw the rise in the SLR? As seen already, the proposed policies can reduce the inflation rate. This has an interesting implication. Note that the nominal interest rate equals the (expected) inflation rate plus the real interest rate. So, as the inflation rate comes down, the nominal interest rate will fall on its own. At this stage, the RBI can remove the rise in SLR in a phased manner.

We have now two counteracting forces on interest rates under the proposed policies. First, nominal interest rates tend to fall due to a reduction in the inflation rate. This is the macroeconomic effect. Second, interest rates can rise when bond prices fall due to sales of bonds once the rise in SLR is withdrawn. This is the financial effect. Seeing how strong each of the two opposing effects is, the RBI can calibrate the pace at which the rise in SLR can be reversed. This completes the proposed policy package.

It is unfortunate that many use the terms monetary policy and interest rate policy as if these are synonyms. They are not. A good example is the proposed set of monetary policies that exclude a change in the interest rate and include a change in the SLR. 

All this raises a question. When the RBI is concerned about high and persistent core inflation, why does it think in terms of raising interest rates and not raising the SLR? Here it will help to consider some history. The SLR had been increased all the way to 38.5 per cent by 1990 to help the government finance its fiscal deficits. Since then it has been reduced now and then, and it is at present at 18 per cent, which is still quite bad. This is because funds invested in government securities cannot be used for giving loans to businesses, homebuyers, and so on. A high SLR can reduce GDP growth. In this context, any advocacy of an increase in SLR is not welcome, and rightly so. However, what is being suggested here is only a temporary rise and that too for macroeconomic purposes and not for fiscal reasons. 

The writer is visiting professor, Ashoka University.

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