Falling Rupee-Rising Inflation & RBI

The current spurt in inflation could have been prevented. Here are the consequences of not checking this inflation in the first place.

 

Inflation.

This word has been weighing heavily on the minds of the world’s biggest leaders and economists for quite some time now. And rightly so. After all this record-high inflation is emptying all our pockets faster.

Currently, there’s a lot of debate about whether this inflation could have been predicted and prevented and how it got so out of hand.

Let us look at a recent paper published in the RBI bulletin which makes an attempt to highlight what exactly went wrong.

Factors leading to Inflation….

A lot of economists believe that this inflation was inevitable.

After all, the RBI and other central banks and governments had infused a lot of liquidity in the market during Covid in the form of low interest rates and stimulus cheques.

So, more money was chasing the same amount of goods, thus leading to inflation.

However, the new paper suggests a different reason.

The paper’s authors (who belong to the Department of Economic and Policy Research) claim that unlike what was previously believed, their research suggests high liquidity did not lead to inflation (at least in India) when the economy has slowed down.

At times like these, the demand is low, so more money is not necessarily chasing the same amount of goods (the criteria necessary for deman pull inflation)

So, what led to this sky-high inflation then?

The central banks, “Jaisa chal rah a hai chalne de” attitude.

You see, they thought that the high liquidity which had kept people financially afloat by ensuring that income doesn’t fall and businesses don’t close during Covid, could help sustain economic growth even when we opened up. But this became a problem when we finally went back to normal and the demand for things shot up.

High demand + high liquidity + low supplies due to supply chain crisis = Perfect recipe for record-high inflation.

And the longer the central banks waited to raise interest rates, the higher inflation grew.

Until finally, central banks raised interest rates (not once but multiple times) to make sure we can control it.

And this has worked actually, as our inflation rate has gone down from 7.79 % to 7.04% after two successive rate hikes.

But raising interest rates has led to newer problems.

The whole world has woken up to the inflation threat at roughly the same time. So, central banks everywhere are raising interest rates.

This, plus the high inflation, has caused the rupee to decline. How?

You see, as the US Federal Reserve and other central banks are raising rates, more people are withdrawing cash from India. They will now get a higher rate of return if they invest it in other countries.

Result? Foreign currency is becoming rarer in India.

And this imbalance, just like the imbalance between demand and supply, leads to a lot of issues.

Supply of foreign currency is low, while demand for it is high (thanks to our numerous imports) which eventually leads to foreign currency getting more expensive.

The rupee has hit an all-time low recently of 78.29 as compared to the dollar.

And this is a major problem for us as we import a lot of stuff, especially oil, which is anyway getting more expensive every day.

So, we need to boost the rupee but how?

Don’t you worry, the RBI is working on it.

It is selling dollars from our foreign reserves in the markets to make sure there is an ample supply of the currency and the rupee doesn’t lose its value.

But the problem with this is that dollar reserves are limited.

We’ve already come down to $ 596 billion in reserves from an all-time high of $ 642 billion in September 2021.

And this amount is enough for only 10 months of imports.

The other way to boost the rupee?

Reduce inflation, increase interest rates and strengthen the export industry.

All of this we’re already working on.

Now, only time will tell if these policies will actually be able to help us reduce inflation and boost the rupee or if we’re truly in for a difficult time ahead.

Summarizing: Inflation is out of control because of RBI’s policy of keeping interest rates low even after the economy opened up and even though we have now raised interest rates, the rupee is still tanking.