It is true that the annual inflation rate has now come down meaningfully from 5.22 per cent in December 2024 to 4.31 per cent in January 2025. This seemingly justifies a cut in the repo rate from 6.50 to 6.25 per cent by the Reserve Bank of India on February 7.
However, the big picture is different. The new “low” inflation rate of 4.31 per cent is still above the 4 per cent target! More importantly, when inflation had previously come down closer to 4 per cent a few times earlier over a period of more than five years, it had returned to a higher rate soon enough.
So, it is premature to say that high inflation is under check now — more so as the inflation rate has been well above the 4 per cent target for more than five years now. A cut in interest rates is only one part of the monetary policy.
The RBI is also expanding liquidity in a big way. This is for two reasons. We have a liquidity deficit due to the recent large tax payments to the government. This temporary deficit in liquidity indeed needs to be taken care of, given the banking and monetary system that we have. The other reason for expanding liquidity is, however, debatable.
The other reason is that if the banks were to maintain adequate cash, this will reduce bank credit, given the total assets on their balance sheets. But the RBI is averse to this, given the relatively low growth rate of GDP at about 6.4 per cent in 2024-25 compared to 8.2 per cent growth rate in 2023-24.
Growth factor
However, there are several issues here. It is possible that the earlier high growth of GDP was extraordinary, and not the new normal. It is also possible that the so-called high growth was actually just a part of the very long process of recovery from the negative growth of GDP in 2020-21.In either of the two cases, the more recent growth rate of GDP at 6.4 per cent is not quite low in which case the RBI need not intervene. It is, of course, also possible that we do have a low growth rate of GDP now.
However, it still does not follow that the RBI should expand liquidity aggressively. Why? It is not clear if the solution to the low growth of GDP lies in higher credit and lower interest rates — more so as such an expansionary policy can cause or accommodate high inflation. This is a serious concern at this stage, given that the inflation rate has been well above the 4 per cent target over more than five years. There is a lesson from that long experience.
In early 2019, the RBI started reducing interest rates to deal with the then economic slowdown.
However, by the end of 2019, inflation had reached 7 per cent. In 2020 and in the first quarter of 2021, the RBI kept the repo rate at 4 per cent, given the crisis due to Covid-19 and the very severe lockdown imposed by the government.
Food inflation
Then, after the Ukraine-Russian war started in February 2022, and there were supply disruptions, inflation was high in India though we had imported oil at low prices from Russia. In the middle of 2023 and in much of 2024, we had high food price inflation. It is, however, not well known that such inflation was not even a South Asian phenomenon, let alone a global phenomenon. The implication is that free trade could have helped to some extent.
But there are, in practice, excessive restrictions in India on international trade in food items. So, the high food inflation was “inevitable”.
Finally, coming to the more recent period of the last 1-2 months, we have already seen what has transpired. The larger point here — and this is the point that the RBI and also the government are missing — is that there has been a “reason” at just about every stage for more than five years to explain or accommodate high inflation. And, this can go on and on! Clearly, something is wrong in this broader perspective.
Inflation mandate
The RBI needs to reconsider its basic approach and seriously return to the mandate that it has been entrusted with, which is to maintain inflation in a sustained way at close to 4 per cent. That mandate came after careful deliberations over three years from 2013 to 2016. Of course, it will help if the government contributes in taking care of some of the non-monetary issues involved in maintaining low and stable inflation.
In any case, RBI’s mandate allows for a leeway of plus/minus 2 percentage points around the target of 4 per cent inflation. This leeway may seem small. It is, however, actually a very large leeway of 50 (= (2/4).100) per cent. The RBI has often implicitly claimed success as the inflation rate has been, by and large, less than 6 per cent. But that is the upper bound in the mandate; it is not the target rate. This is not about splitting hairs.
It is about arresting the creeping dilution of the mandate, which is not to say that there is any ill intention at the RBI. There are two difficulties with high inflation. First, if 4 per cent is the optimal inflation rate, then obviously a higher inflation rate for long creates an overall loss to the economy.
Second, we have redistribution, which takes various forms. An important part of this story is as follows. Due to inflation, purchasing power of money falls for the public but the RBI “earns” by printing or issuing money at negligible cost. And, excess money is inflationary.
RBI passes on the so-called dividend income to the government. So, the latter gains while the public loses. For all practical purposes in India, this redistribution is higher, the higher is the inflation rate. It is plausible that the main loss is borne by the less well-off and the less well-informed. We need a basic change in policy.
The author is an independent economist. He has taught at Ashoka University, ISI (Delhi) and JNU
