RBI’s Fixation with Inflation

RBI’s Fixation with Inflation
RBI’s Fixation with Inflation

Inflation refers to the measure of rate at which the average price of commodities and services rises over a period of time. In India Consumer Price Index (CPI) is used as the standard measure for measuring inflation. In the early years of the current decade high food inflation was seen that gradually became generalised. Subsequently, inflation spread to rest of the economy. India has been witnessing slowing down of economy since 2016 that is continuing till now. In December last year the inflation rate overshot the 7% mark and was recorded as the highest in five years with inflation rate exceeding the permissible range of error by 65%. India is going through a phase of non-uniform nature of price rise with food inflation crossing the 10% mark and at the same time sectors like manufacturing have witnessed deflation due to drop in demand for products. Headline inflation has been steadily increasing from 1.97% in January 2019 to around 4.5% in October 2019, Wholesale Price inflation is going downwards, Core inflation will also move towards deflation due to weak demand and at the same time Consumer Price inflation will overshoot the RBI’s targeted central point of inflation. The value of GDP growth (that is the sum of real growth and inflation) went down to 8% for 1st quarter of 2019-20 lowest since 2002-03.

This trend of low GDP growth has its repercussions because tax collections depend upon nominal GDP growth and if nominal GDP is lower than tax collections targets cannot be met which in turn will force the government to slash expenditures to meet the fiscal targets. The current trend of inflation has other effects on public like in the past three years the annual increase in salaries has barely been in double digits and this combined with low inflation shall allow individuals to but the same amount or more as per economic theory. This ultimately discourages individuals from spending on large items like vehicles and consumer goods. There has been a sharp rise in inflation in almost all vegetables along with cereals (mainly wheat and coarse cereals), pulses etc also, recently the market witnessed sky rocketing prices of onion. This upheaval caused in the market due to changing inflation has had its severe effects on people. Inflation affects almost all sections of the society and certain group of people gain as the cost of other like in case of sellers who will tend to sell the goods at higher rates thereby gaining more profit and the customers who will have to pay higher amount for goods thereby facing loss. Inflation also affects borrowers and lenders differently with the former gaining and the latter facing a loss. Inflation results in a drop in the real purchasing power of people earning a fixed income thereby such people tend to lose due to inflation whereas people with flexible income tend to gain during inflation. Inflation in economy leads to general slowdown of economy which results in the rise in unemployment rates, decrease in purchasing power of consumers, expensive credit, discourages heavy investments by both domestic and international players etc. Thus, it ultimately strains the financial system of a country.

How RBI Controls Inflation? And Steps Taken in Recent Times

RBI is the central bank governing over all other banks in India. As the central bank RBI has a major role to play in controlling inflation and bringing stability in the economic condition of the market. In order to control inflation RBI has number of tools that it makes use of in case of rising prices in the market. RBI adopts monetary policies as short-term tools to regulate economy by keeping inflation in a comfortable zone. RBI makes use of quantitative tools in order to control inflation. Quantitative tools used by RBI are Repo rate (rate at which RBI lends to banks on short term basis), Reverse repo rate (rate at which RBI takes loans from banks), Bank rate (rate at which RBI lends to banks for long term), Reserve ratios (Statutory liquidity ratio-portion of net demand and term liabilities of a bank to be maintained in form of highly liquid assets and Cash reserve ratio-portion of net demand and liabilities of a bank to be maintained in form of cash with RBI), Open market operations (purchase and sell of government securities), Marginal standing facility rate (Banks borrow from RBI at this rate which is higher than repo rate if it is running out of government securities). For controlling inflation RBI increases its lending rates in terms of increased CRR, SLR, Repo rate, Bank rate etc. On increasing these rates banks and other lenders need to pay higher interest rate to RBI for obtaining money from it, this increased rate is then passed on to customers who have to borrow money at higher rate of return. Subsequently, people tend to avoid borrowing and spending thereby decreasing their consumption which leads to a decrease in demand in the market and results in decreased prices thereby controlling inflation.

In recent times, RBI has instituted inflation targeting approach as the sole monetary policy doing away with its earlier followed approach involving multiple indicators. The government adopted modern monetary policy framework for RBI as per which RBI is solely responsible to control inflation and it was permitted to exceed or fall short of a targeted inflation rate of 4% by a margin of 2%. RBI has been focusing more on infusing liquidity in the market in order to boost demand keeping aside the rising food inflation. RBI in its 2019 October policy announcement projected 3.8-4.5% retail inflation for the second half and went ahead with changing its policy stance from “neutral” to “calibrated tightening”. It also adopted some small measures like easing foreign investment norms, going ahead with mild intervention in the for-ex market in order to address the financial risks posed by slowing economy and falling value of rupee. In 2016, post the amendment of the Reserve Bank of India (RBI) Act-1934, RBI adopted the Flexible Inflation Targeting Framework (FITF) as per which the inflation target for the period between 5 August 2016 and 31 March 2021 has been fixed at 4% of the Consumer Price Index (CPI). And the government has set upper and lower tolerance limits of 6% and 2% respectively. RBI’s approach of inflation targeting has involved use of increased interest rates to keep inflation under control. However, this approach of RBI via inflation targeting as its primary mandate has inevitably lowered growth and RBI has not been accountable for rising unemployment in the country.

Has RBI’s Approach of Inflation-Targeting Led to Failure of its Other Functions?

The primary aim of formation of RBI was to maintain financial stability and deal with failure of private commercial banks due to malfeasance or misjudgement. RBI would act as the lender of last resort but with checks in the form of tough regulatory stance towards activities of banks mainly in terms of risky lending. RBI would help prevent the collapse of credit and thereby prevent the downturn in the entire financial system in case any bank malfunctions. This in turn would protect depositors from bearing the loss due to activities of banks. In the recent times following the footsteps of west and with the rise of neo-liberalism whereby market has been given free play, RBI’s regulatory function has taken a backseat. This is because the model on which inflation-targeting is based, not much stress in given on public regulation and the major role of central bank has been confined to regulation of inflation only. Prior to this approach, RBI was concerned with inflation control and it was equally concerned with maintaining financial stability and balancing the level of economic activity.

After adoption of inflation targeting by RBI, growth in India has slowed down considerably and financial sector has seen stress in terms of rising non-performing assets of public sector banks and also instability in the private segment of financial sector. After adoption of inflation targeting approach number of crises have been seen in the financial sector. In 2018, ILFS,  a non-banking financial company in field of infrastructure defaulted on several fronts including repayment of bank loans, redemption of commercial paper etc and had a debt of around 94000 crore rupees (some part of burden faced by the company was due to slowing economy but traces of malfeasance were also present in the case). In 2019, in a similar case of malfeasance in the Punjab and Maharashtra Co-operative bank it was seen that about 21000 fictitious accounts had been created for tallying of books and the deposits were siphoned off as loans to promoters. Improper conduct also was seen in cases of Yes bank, ICICI bank, Bengaluru based Sri Guru Raghavendra Sahakara bank. Such cases display a clear failure of regulatory function of RBI. Besides this, RBI has also failed in currency management for facilitation of trade- even though RBI has a monopoly on issue of notes, in present times there is an absolute shortage of small denomination notes in the Indian market in almost all sections like trade, village stores, commerce sites etc and due to this absence of appropriate denominations transaction has been affected thereby adversely affecting production. Failure of RBI in its diverse roles has become a major cause of concern because even after diverting its focus on inflation control at the cost of its regulatory and other functions, RBI has been unable to deliver in terms of inflation control which has lead to a crisis on both fronts i.e increasing inflation and increasing instability in the financial sector.

How can RBI Balance its Functions?

RBI needs to maintain a balance between its regulatory functions and inflation control as both have a significant role to play in a developing economy like India. Opting for only inflation targeting will not be helpful as there is a need to look past inflation and address the imbalance in the economy because inflation may be due to temporary factors like rise in prices of select food items such as onions, or it may be due to disruption of supply in some parts due to conditions like heavy rains etc. RBI has been focussed on inflation control neglecting the regulating role and in both the fields it has failed and has resulted in an increase in inflation along with financial instability. In such a scenario RBI needs to adopt a more nuanced strategy giving due importance to inflation and also regulation of financial sector. With the weak economic condition and soft trends in headline CPI of Indian market there is need to return to a “neutral” stance from RBI’s current “calibrated tightening” stance. RBI must strive for a synchronised policy taking into account both monetary as well fiscal policy. RBI also needs to recalibrate its ideas about neutral or equilibrium real rate of interest which will help in keeping growth in a steady condition and will keep inflation confined to the formal target. Lastly, RBI needs to re adopt its old multiple indicators approach which allowed more discretion and was more suited to Indian economy compared to current inflation-targeting framework that has failed in both the fronts of maintaining inflation within limits as well as maintaining financial stability. Growth should remain as RBI’s central agenda at least until the time Indian economy is back on a higher trajectory in terms of both inflation and growth rate.


RBI is the central bank in India and it has a major role to play in maintaining financial stability in the economy. However, RBI’s role must not be limited only to maintaining financial stability because another significant role of controlling inflation also has to be the responsibility of RBI as it is best suited to deal with the forces of market affecting inflation. A well laid out approach whereby RBI simultaneously plays the role of a regulator as well as inflation controller needs to be adopted. Moreover, RBI adopts monetary policy to control only the short-term inflation and long term inflation can be controlled only by the government’s taxation policy, long run interest rates, long run production plans and by adopting changes in supply side of the market. So, in such a condition forming a separate department to control inflation will further diversify the already vast banking structure in India and will raise complicacies with respect to functioning of the department and tools to be handed over to the department for inflation control. On the contrary RBI is well equipped to deal with inflation control and a proper approach like the old multiple indicators approach of RBI will be effective in ensuring that RBI efficiently keeps inflation in check and simultaneously it also fulfils its duty as a regulator thereby maintaining balance in the financial sector.


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