Monday, October 24, 2011

Why interest rates will rise... And inflation too.

It's policy time again and as usual, speculation about the RBI's stance later today is more than rife. Some commentators feel that the RBI has hiked rates enough. Others feel that more hikes are warranted as inflation continues to remain at ridiculously high levels. Both sides, however, fail to provide for the anomalies of the Indian economy and suitability of traditional policy instruments to the task at hand.

Theoretically, when faced with high inflation, a central bank hikes interest rates which serves to reduce inflation in two ways. Firstly, higher interest rates suppress domestic demand which robs local businesses of pricing power. Reduced domestic demand also reduces the quantum of imports which results in improved balance of payments and currency appreciation. This, in turn, lowers the price of imported goods with it's consequent salutary impact on inflation.

Secondly, in an open economy, higher interest rates attract foreign capital which results in currency appreciation and hence, lower prices for imported goods which in turn serves to ease inflationary pressures. This impact, however, can manifest only when the country in question has an open capital account for debt flows.

When analyzing the applicability of these theoretical outcomes to India, one is immediately aware of a critical gap. India's capital account is completely open only for equity flows, not debt flows. As a result, higher interest rates are seldom accompanied by greater inflows of foreign capital. In fact, as higher interest rates squeeze domestic economic activity and corporate profitability, foreign equity flows reduce or even reverse. This worsens the balance of payments and can, and frequently does, result in currency depreciation at such times. As the currency depreciates, the prices of imported goods rise which adds to inflationary pressures rather than easing them. This makes it extremely likely that in India, with the existing framework, higher interest rates will cause higher inflation rather than combatting it.

Recent evidence supports this theory almost completely. For the second time in the last 4 years one can witness the currency collapsing and inflation increasing as interest rates rise. When inflation subsided somewhat in 2008/2009 as international commodity prices crashed it gave the RBI the unfortunate impression of a monetary policy success. With the RBI looking to replicate this 'success' once again, it is more than likely that interest rates will rise once again later today. And in the absence of a complete collapse in international commodity prices, so will inflation.