The demand-supply equation in the money market was in balance till now. Sucking out Rs 38,000 crore over the next month, through the imposition of a higher CRR, will therefore tighten money supply noticeably. That would have sent up interest rates, even without the hike in the repo rate. This is also a time when the demand for credit has been strong, in part because companies have switched funding from the stock market (now cool to IPOs) to the debt market. The RBI has now said that the debt market too is going to be more expensive. In short, the pressure on companies to slow down borrowing, and therefore economic activity, will be clearly felt.
The one fact that everybody must come to terms with is that the monetary response to inflation will lead to slower growth. It is misleading for prominent policymakers to claim that inflation can be brought down without compromising on growth. Even in the absence of monetary measures, the rising costs of energy and other inputs were taking their toll of corporate margins, causing many of them to defer or scale down their investment plans. Consumers hit by rising prices are also likely to re-allocate their household budgets to reduce spending on discretionary goods and services, and to delay the purchase (say) of that new car. While the monetary tightening and higher cost of credit will intensify these adjustments in the immediate future, thereby causing growth to slow even further, they are justified by two considerations. One, they serve to persuade companies, workers and consumers that the government will do whatever it takes to fight inflation, favourably influencing perceptions about the future state of the economy. Two, they neutralise the potential expansionary impact of a widening fiscal deficit caused by the government's reluctance to rein in its subsidy bill by passing on price increases to consumers. Ironically, even though greater price adjustments will increase the inflation rate for a while, their macro-economic impact would also be to slow down growth, eventually leading to lower inflation. The quicker these adjustments are made, the less the pressure on the RBI to respond. However, an additional benefit of higher interest rates should be to slow down, even stop, rupee depreciation, which will also contribute to easing the inflationary pressure.
Ultimately, given the global nature of the inflation problem with regard to commodity prices, particularly oil, the inflationary pressure will only subside when everybody begins to consume less, or consume more at a slower rate. From this perspective, the RBI's actions may not guarantee that the problem will be solved but they are consistent with the appropriate collective response. All governments need to make their contribution to the process by speeding up energy and other price adjustments.
