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Inflation and Interest Rates

For past many months India has been suffering from a high rate of inflation with the general level of prices for commodities and raw materials rising at an alarming rate. Highinflation has also kept R.B.I. from cutting key interest rates. For December 2012, inflation was at 7.18% as compared to 7.24 % in November and 9.46 % during the corresponding month of the previous year. You can check current inflation, interest rate and GDP data here.

This is high. This is really high for Reserve Bank of India (R.B.I) to soften its guard on inflation and for good reason. Advanced economies consider inflation levels in the region of 2-3 % to be acceptable.  There should be no different standard for emerging economies such as India. Why must RBI raise the acceptable level of inflation and cutkey interest rates

Relationship between Inflation and Interest rates

Inflation and Interest Rates

Inflation: Inflation is defined as a continuous increase in the general level of prices for goods and services or an increase in the money supply (which would generally increase the level of prices for goods and services). It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller percentage of a goods or services.

Interest rate: The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate.

There are two divergent points of view on the relationship between growth on the one hand, and inflation and interest rates on the other:

►    To stimulate growth, low interest rates are required: If repo rates were cut, banks would have passed it on by reducing their lending rates. This, in turn would stimulate investment because the lower cost of borrowing would encourage more consumption. A higher interest rate reduces the demand for goods. This in turn lowers the level of consumption and output.  There is thus a negative relationship between output and the interest rate.

 ►    To control inflation, interest rates need to be constant: Rising demand can trigger off more inflation. Interest rate reductions could lead to further inflationary pressure since availability of more liquidity (i.e. money) in the economy gives rise to depreciation in the purchasing power of money.

Role of R.B.I. in choosing between stimulating growth and reducing inflation is tough. Interest rate changes benefit one variable at the cost of the other. The problem is in identifying the exact threshold level at which inflation is considered to be at a comfort level. India’s threshold inflation should be between 4.0%-5.5%1.

Inflation number for the month of December 2012 came at 7.18%. This is clearly above the comfort level of R.B.I. However, the Finance Ministry has been consistently pitching for the need to stimulate growth and there is high likelihood that the R.BI. Governor will ease the interest rates on the 29th of January when R.B.I comes out with its policy review.

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Reserve Bank’s Working Paper titled “Inflation Threshold in India: An Empirical Investigation” authored by Deepak Mohanty, A B Chakraborty, Abhiman Das and Joice John.