Monetary Policy Committee Of The RBI Hikes Policy Rate By 25 Basis Points

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New Delhi: Monetary policy committee (MPC) of the the Reserve Bank of India has hiked the policy rate by 25 basis points on August 2 to 6.5%. This is the highest in two years. One basis point is one hundredth of a percentage point.

The decision was in line with most polls. The MPC’s statement says that the June round of RBI’s survey of households reported a further increase of 20 basis points in inflation expectations for both three-month- and one-year-ahead horizons compared with the last round. These values have increased significantly in the last one year. Put simply, this means most people expect inflation to rise.

The question which needs to be asked is whether an interest rate hike at the present juncture can help contain inflation? A short digression on the conceptual basis of inflation targeting is useful here. The argument that an interest rate hike controls inflation assumes higher rates increase the cost of capital and hence prevent an economy’s actual output from overshooting its potential output. Actual output exceeding potential output is thought to be inflationary because it creates excess demand for scarce resources at a given point of time.

The MPC statement lists five factors which will shape the inflation outlook: a larger-than-average increase in minimum support prices (MSPs) and a good monsoon affecting both food and normal inflation, crude oil prices continuing at elevated levels, a softening of inflation due to the government’s decision to cut the Goods and Services Tax (GST) on several products and services, and the pass-through of rising input costs and improving demand conditions on general inflation.

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