The unwelcomed hike
The world is being hit by recession and inflation(cost-push) for majorities of the economies, the US Fed is inclined towards further increasing the borrowing cost to bring down inflation to their 2% target.
Our nation is following a similar policy of tightening policy rates as a measure to curb inflation, but if we give it a thought, inflation is a concern but so is over-tightening. The external members of the MPC (Monetary Policy Committee) warned that an increase in policy rates (Repo rates) is a measure to curb inflation, but at the same time affects the growth of the nation. An esteemed professor at the Indira Gandhi Institute of Development Research stated that raising real interest rates reduces demand but has a stronger effect on growth than it does on inflation.
Let us understand how?
Currently, India is facing cost-push inflation and also stagflation. An increase in interest rates pulls liquidity resulting in demand getting reduced but is an increased demand a problem in India? No, the inflated costs are a result of the cost of production is high. By increasing repos, we are hitting the wrong side of the economy, trying to reduce demand which in reality is not the problem area. Further, a higher borrowing rate will increase the cost of borrowing for manufacturing which will lead to nothing but the increased cost of production once again, which will increase prices and hit the stomach of the middle and lower-income groups.
There are more lags in monetary transmission in India, overshooting can have persistent deleterious effects, including instability. Besides, macroeconomic stability improves more rapidly if real interest rates are kept smoothly below growth rates and counter external shocks.
The question arises is an Economy like India with high unemployment, unequal distribution of wealth, low growth rate, and many macro-level problems ready to take such shocks?
Kautilya, IBS Mumbai.