Two problems, one strategy for both RBI and the Fed

September 12, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The Reserve Bank of India and the U.S. Federal Reserve were confronted with two different problems but used the same monetary strategy for solution. Neither succeeded.

The RBI had to pull down inflation and raised the repo rate in eleven steps in eighteen months by 3.5 percent. The expectation was that the rate rise will curb demand and lower prices. What happened was entirely different.

Headline inflation is still over 9 percent, largely backed by inflation in food, mainly fruits and vegetables, meat and eggs. Interest rate made no difference to food inflation because no one buys food from money borrowed from banks.

But the RBI did succeed in curbing demand for a variety of other products. With the high interest rate, demand for housing declined and construction activity slowed down. With the high interest rate, demand for cars and trucks dropped and production became stagnant and would even shrink. With the high rate of interest many industrial projects became unviable and investment declined. And so on.

All in all, GDP growth in the second quarter was down to 7.7 percent from 8.8 percent y-o-y. This was precisely what the RBI was looking for. But it had also expected that, with lower growth, inflation would fall. That did not happen simply because inflation was not due to over-heating of the economy but shortfall in critical food supply.

The Fed was expecting exactly the opposite to be achieved with the same strategy. The rate of interest was drastically cut and the Bank poured in trillions of dollars to keep that rate in check, hoping that investment and consumption will revive and unemployment will be reduced. Neither took place.

Unemployment touched 9.1 percent with the added threat of the U.S. dipping into a second recession. Interest policy proved to be too weak for the target.

The RBI and the Fed relied on monetary policy which, in both situations, was not adequate to tackle the problems at hand.  Instead of restraining inflation, the RBI, in its over-enthusiasm, actually restrained growth. Its expectation was that the trade-off between growth and inflation would work out. It did not. Result? Low growth and high inflation.

In the U.S., banks were loaded with liquidity for which there was neither willingness to lend nor willingness to borrow by industry. Mere money with the banks does not generate demand by the consumer or the investor. In spite of low interest and high liquidity, growth failed. It is no surprise that U.S. President Obama finally had to come out with a jobs plan with expenditure of $447 billion.

The RBI is unlikely to change its strategy in spite of convincing evidence that it has gone overboard. On Sept 16, the central bank will be out in the field again to fight inflation. Surely, the rate will not be reversed to pep up growth; at best, the bank may take a pause after the hasty steps at the last review.

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