Analysis: RBI's overdrive to tame inflation may backfire

The inevitable has happened but it was expected. In fact, the macroeconomic and monetary developments released yesterday had already prepared the market for the inevitable. So, the repo rate has been raised twice within a period of six weeks though some fine tuning has been done on the marginal standing facility. The war with inflation has been raised to a higher level. But will it lead to expected results? Not likely.

It is clear that the second quarter review of the monetary policy has been prepared in a backdrop of very difficult times, both globally and domestically. The IMF had recently revised downwards global growth rate implying a difficult market for our exports. Domestically, almost every macroeconomic indicator has been critical, be it industry, construction or services. Agriculture which constitutes less than 14 percent of GDP, despite good a monsoon, cannot be expected to significantly influence overall growth rate. Neither the fast clearance of delayed and stalled projects, despite fierce election battles, can immediately influence growth as there generally is a gestation lag. Fiscal slippage is apparent but given that governments' borrowing costs are lower than last year despite rise in average maturity, fiscal profligacy is anticipated.

The rise in interest rates may not yield higher deposits as only few save through the banking channel while others save in gold and real estate, especially when economic uncertainty is high and black economy is flourishing. And if global sentiments change, capital outflows would still occur because of prevailing economic environment. Thus, hike in interest rates will only further stifle growth, resulting in higher unemployment.

Traditionally, any responsible central bank, to safeguard the interests of citizens, would tighten the monetary policy when fiscal profligacy, especially during the election year, is noted. But if it impinges on growth and unemployment -other two objectives of monetary policy - then the monetary stance needs to be boldly revisited and not considered through traditional lens.

Inflation is mainly impacted by select food items and not because of demand pressures that monetary policy is seeking to address. Use of brahmastra or using an army tank to battle an alligator, may have been unwarranted.

The writer is also Professor of Economics, IIM Bangalore