The central bank asserted that a policy of tolerating inflation will not yield the desired results.
“While lower real interest rates can stimulate growth and investment, the central bank cannot adopt a policy of higher inflation tolerance as the means to lower real rates because beyond a threshold, the negative impact of inflation on growth outweighs its positive impact,” the RBI said in an issued statement.
Inflation Dampens Consumption Demand
The central bank of India cited a recent study to justify its stance. The said study has been conducted in the wake of increasing criticism that the bank is following an anti-inflationary monetary policy which in turn is hindering growth.
As a policy matter, the RBI the RBI has attempted to rein in inflation since July 2011. The bank has kept the repo rate above 8 per cent for 18 months on the trot. It was only at the start of 2012-13 fiscal year that RBI reduced the rate by 1.25 percent.
“...tolerating higher inflation with growth-supportive monetary policy response is unlikely to stimulate growth to the desired extent since the adverse impact of higher inflation on growth would more than offset the favourable impact of growth-supportive monetary policy,” RBI said, citing the study titled ‘Real interest rate impact on investment and growth –what the empirical evidence for India suggests’.
RBI stated that high inflation tends to dampen consumption demand. The bank suggested that lower real rates had a bigger role to play than inflation in boosting the investment demand. Real interest rate is the difference between the actual interest rate and the rate of inflation.
The “100/50/20” Formula
Citing the study, RBI said that there was “empirical evidence that lower real interest rates can stimulate growth and investment, it does not recommend a policy of higher inflation tolerance as the means to lower real rates."
The inter-departmental study, carried out RBI’s monetary policy department and the department of statistics and information management, establishes a “100/50/20” formula. The formula suggests that a 100 basis point increase in real interest rates leads to a decline in the investment rate by about 50 basis points and at the same time moderates the GDP growth rate by about 20 basis points.
The Reserve Bank of India (RBI), which has drawn a lot of criticism for not cutting interest rates at the desired pace and thus stifling growth, stated that it is not in favor of keeping the inflation high as a means to propel economic growth.