Will a rate hike by RBI help tame inflation?

We will know the outcome of the RBI’s Monetary Policy Committee meeting in a few hours from now. The consensus is that the MPC will vote to increase benchmark rates since inflation is running high. But will a rate hike help tame inflation? Well as they say in advertisements, conditions apply.

How does it work? Everyone knows that prices are determined by the supply and the demand for goods and services in an economy. As such, the price rise in any given situation may be caused by either an increase in demand or lack of supply or both.

Now, the RBI MPC has only monetary tools which arrest demand by making money more expensive or by reducing its supply. Typically, it raises the repo rate, which is the interest rate at which RBI lends overnight money to commercial banks against government securities.

This transmits into an increase in interest rates, both lending and deposit depending on the given situation, of lenders though with a lag.

RBI also has other monetary instruments in its hands such as cash reserve ratio (CRR) which is a portion of a commercial bank’s total deposits that needs to be maintained with the RBI.

In the off- cycle decision, the MPC had raised the repo rate by forty basis points and CRR  by 50 in May. Both these measures, as cited above, reduce demand in the economy. So, a repo rate and CRR hike ought to help tame inflation, right?

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Like we said, conditions apply. Inflation is not affected by money supply alone. The current high inflation has more to do with disruption of supply, caused by the ongoing Russia-Ukraine war which has raised commodity prices such as that of crude oil, fertiliser. This in turn has an impact on food inflation. Besides, it has reduced the supply of sunflower oil as Ukraine was the world’s biggest exporter before the war.

There are seasonal factors too which have raised inflation in lemons, tomatoes, and wheat. MPC’s monetary tools cannot tame this kind of inflation. However, part of inflation is also due to some revival of demand in the economy as it gradually recovers. Monetary policy reduces this demand which will negatively impact economic growth. Monetary tools also prevent inflation from entering other areas such as from food to wages to rent etc. In other words, it reduces inflationary expectations in the economy.