Soaring commodity and fuel prices have hit people so hard that many are struggling to manage their families on limited incomes. Given that there are few more politically sensitive topics in India than inflation or rising prices, the decision of the Reserve Bank of India (RBI) to remain accommodative in its monetary policy and not to raise rates of interest has raised questions.

The RBI has stuck to its stance of not disrupting growth for now by saying that while there is robust growth in some sectors, it is uneven across sectors. But sustained price increases without growth in aggregate demand will hit the economy harder. The RBI’s position comes at a time when most emerging economies have raised interest rates in the post-pandemic world.

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“We have decided to remain accommodating in our monetary policy, while closely monitoring the development of the inflation scenario,” RBI Governor Shaktikanta Das said Thursday in his speech at the annual meeting of the International Monetary Fund and from the World Bank.

The RBI Trilemma Moment

Mundell and Fleming proposed an impossible trilemma in economics. Their model states that a country can only have two of the following three conditions:

1) Free currency flows

2) Sovereign money flow

3) A fixed and stable exchange rate

The fall of the rupee and the rise in yields after the RBI monetary policy can be explained as follows. India has an open capital account, but with minor restrictions. The world over emerging economies such as Brazil, Russia, Poland, New Zealand, among others, have raised interest rates. Norway, which is a developed economy, has also increased its interest rates.

In addition, Germany, a country that had been on the brink of deflation for many years, experienced the highest inflation rate of 4 percent in more than three decades. The Bank of England has moved quickly to cut the bond buying program and is expected to raise rates. Even the US Federal Reserve has indicated that it will start to decline from November. Yields on 10-year US Treasuries crossed 1.5% to 1.6%.

However, the official RBI Consumer Price Index (CPI) figures have hovered around 6% for some time now, while the Wholesale Price Index has been in double digits for four consecutive months.

Fuel and food inflation is skyrocketing. The prices of steel and metals keep increasing. Automakers and manufacturers of consumer durables pass the costs on to the consumer. The RBI ignored these pressures when formulating prices.

Rising global demand after the pandemic has pushed crude prices to a multi-year high. The Indian government passed this increase on to the consumer instead of reducing usurious taxes. The RBI taking an accommodating stance in the face of such overwhelming evidence puts the economy in a precarious position.

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Moreover, the RBI has chosen to operate on its own, ignoring the rest of the global monetary policy of rising rates. The RBI has also decided to maintain the free movement of capital. Therefore, according to the impossible trilemma principle, they have very little control over their exchange rate.

The RBI should be prepared to face a race of foreign investors when the United States decides to scale back its quantitative easing. A massive depreciation of the rupee against the dollar would occur in such a situation. This means that the import industry and the general price level will suffer from rising prices for crude oil and other imported products.

A sustained increase in prices (inflation) without growth in aggregate demand will lead to stagflation of the Indian economy. This will cause the RBI to eventually raise interest rates, anyway, to curb this impasse, but it will end up being more painful. It’s also important to note that despite the RBI’s extraordinary efforts to control the G-SEC yield curve, 10-year bond rates are rising and there is obvious upward pressure.

The trilemma tells us that despite the RBI’s greatest efforts to control the foreign exchange market, it is impossible if it continues to promote independent monetary policy and the free flow of capital. This theory has been proven in practice, with the rupee depreciating by more than 2% over the past month (September-October).

The RBI needs to tighten its monetary policy and ensure that the ravages of inflation don’t take hold (assuming it hasn’t already). A rate hike would strengthen the rupee, lower imports and lower the price of crude. More importantly, it will keep prices under control, but it will slow down the economy. The recovery we are seeing now is K-shaped and the distribution of wealth is uneven, disproportionately favoring the upper class over the rest.