Rise in Inflation Puts Pressure on India’s Economy

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High inflation rates are plaguing India’s economy and causing tension between the Reserve Bank of India (RBI) and the Indian government. The core inflation rate (rate at which the price of all goods except food and energy changes) in India increased about 5.56% from this time last year and has remained between about 5% and 6% for several months. Meanwhile, wholesale inflation (reflects the price of goods bought and sold by corporations as opposed to individual consumers) stands at around 7.55%. The fact that the wholesale inflation rate in India has been above 7% since 2010 shows that this is not just a short term problem, particularly because the RBI’s target inflation rate is 5%. The RBI is determined to curb inflation through tight monetary policies such as increasing interest rates and cash reserve ratios (CRR) (the percentage of depositors’ money that banks must keep on hand). However, the government blames the RBI’s policies for hindering economic growth by tightening access to credit. Both sides have taken steps to liberalize their economic policies, but tensions remain because the government wants the RBI to do more to help stimulate growth, while the RBI blames the government’s policies for helping to increase inflation.

Inflation hurts both the standard of living of many Indians, as well as the development of India’s economy. High inflation rates disproportionately hurt poor people because the poor do not have the monetary resources to adapt to higher prices, and thus, are forced to lower their consumption. Inflation also hurts both savings and investment rates. Households, in particular, save less because current prices look more attractive than future prices, which encourages people to buy goods right away. Moreover, people must spend their savings to maintain their lifestyle when prices go up faster than their incomes. Household savings declined from 12.2% of gross domestic product (GDP) in 2009 to just 7.8% in 2011. Furthermore, Indians seem to be investing what money they do save in valuables such as gold, rather than in physical assets such as housing. Investment in valuables increased 3.7% in 2008 to 7.9% in 2011. Government savings have also declined in large part because of stimulus measures, which lowered revenue and increased government expenditures at the same time. Consequently, neither private individuals nor the government has enough money to invest and help achieve the government’s goals for developing the economy.

In response to high inflation rates, the RBI raised its interest rates 13 times between March 2010 and October 2011. The RBI lowered the interest rate in April 2012 for the first and only time in three years, and since April, the interest rate has remained at 8%. The RBI also increased the CRR twice during that initial time period, from 5% to 6% of net demand and time liabilities (NDTL) (bank deposits, as well as liabilities to other banks). Higher interest rates help control inflation because they lower the demand for goods and services by making it more expensive to borrow money. Higher CRRs, on the other hand, decrease the overall supply of money in the market, which helps restrain the unit value of the rupee. Unfortunately, these policy measures also discourage private investment for these same reasons—more expensive and less available money. Moreover, analysts, and the RBI itself, blame this monetary tightening for helping to depress India’s expected GDP growth this year to about 5% from 8.4% growth in 2009 and 2010.

To spur growth and temper the effects of its inflation policies, the RBI cut the CRR in September and October of this year to 4.25% of NDTL. However, the government continues to urge the RBI to lower interest rates as well. Recently, the government decided to decrease fuel subsidies, which will help lower the fiscal deficit because it will be expending less money. The government also decided to allow foreign investment in areas such as the retail, aviation, and broadcasting sectors. Lower interest rates would help boost investment in these newly open sectors because it would enable businesses and individuals to access cheaper loans.