The Indian Economy Blog

October 25, 2005

RBI in inflation fighting mode

Filed under: Monetary policy — Reuben Abraham @ 1:09 pm

Given the rise in inflation, it was inevitable. The RBI just announced its decision to increase short-term interest rates by 25 basis points.

The central bank lifted its reverse repo rate, used to drain liquidity from the money market, by a quarter of a percentage point to 5.25 percent, prompting stocks and the rupee to firm and benchmark bond yields to rise.

Tuesday’s widely expected rate rise takes the reverse repo to its highest in 2-1/2 years. It last raised the rate — by a quarter of a percentage point — in April. The central bank surprised analysts by raising the repo rate, used to add liquidity to the money market, by a quarter of a percentage point to 6.25 percent, while leaving the bank rate for pricing long-term loans steady at 6.0 percent. But the central bank suggested further inflationary pressures were in the pipeline, warning markets that higher international crude prices had only been partially passed through into domestic prices and second-round effects were not yet “noticeably significant”.

8 Comments »

  1. Cafe hayek says it best on all this talk of “fighting” inflation. Akin to socialism, our “smart” central bankers end up bravely “fighting” problems entirely of their own making. I suppose it is a childish fascination to press buttons and the like which makes Central Banks so infatuated with tweaking interest rates as opposed to having a more systematic and less wanton creation of money.

    Comment by seven_times_six — October 26, 2005 @ 5:31 pm

  2. And here is Mahalanobis disagreeing with Cafe Hayek’s monetarism.

    Comment by Reuben Abraham — October 26, 2005 @ 5:56 pm

  3. Mahalanobis just seems to be saying that a systematic money creation policy is not a simple thing. Perhaps. But it is not clear to me why the much simpler thing of tweaking fresh money creation is not the answer as opposed to tweaking the interest rates.

    Comment by seven_times_six — October 26, 2005 @ 11:59 pm

  4. seven_times_six
    The main reason that central banks use the interest rate rather than money supply, is that money demand is extremely unstable, and difficult to estimate. India is not unique in this respect.

    Comment by Deep — October 27, 2005 @ 11:39 am

  5. Deep, that does not make much sense.
    Mahalanobis and yourself are basically saying that money demand is difficult to estimate.
    Maybe.
    But GIVEN that you have inflation, and that you want to reduce it, you’re basically *agreeing* upon a particular facet of money supply situation: that it is too much and that you want to reduce it.

    Now, GIVEN that you want to reduce money supply, why not reduce fresh money creation?
    Japan did precisely that when they got a double-digit inflation and they were rewarded by a singular reduction in inflation. Interest rates should be an effect, it is not clear to me why, esp. in the face of empirical success of Japan, central banks should try roundabaout techniques that are not even clear.

    Comment by seven_times_six — October 27, 2005 @ 8:33 pm

  6. seven_times_six,
    The most direct way to reduce inflationary pressures is to reduce aggregate demand. The most direct way to reduce aggregate demand is to increase interest rates. This would reduce both consumption and investment. An increase in interest rates could be engineered through a decrease in the growth rate of the money stock, but _that_ would be an indirect mechanism (and given the instability of money demand, subject to considerable error). In the 70s, there was a minor debate about whether to target interest rates or the money supply, but that debate died long ago once central bankers found out that in practice, tinkering with money supply led to far more uncertainty (about policy outcomes) than tinkering with interest rates. And, I dont quite follow your Japan example. For the last two decades, the Japanese story has been one of persistent deflation rather than inflation. Am I missing something?

    Comment by Deep — October 28, 2005 @ 12:46 am

  7. Another reason for targeting interest rates is their transparency to the markets, helping markets to react and adjust efficiently.

    Comment by Vivek G — October 29, 2005 @ 10:53 pm

  8. The fundamental question is not whether the RBI needs to tweak money supply or interest rates. We need to abolish the central banking system, which is drowning us in debt. Here is how:

    The fundamental issue is a flaw int the way money comes into circulation.

    Money comes into circulation as DEBT issued by banks to producers. When production is consumed the money must be returned to the banks ALONG WITH INTEREST. This interest must come out of the money supply, thereby creating a demand for more bank debt. This is an unending cycle – condemning productive societies to ever-expanding debt.

    Read in more detail about this here: http://dkd.net/davekidd/politics/moneyapo.html

    Comment by Arvind — September 12, 2006 @ 3:37 pm

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