Surjit Bhalla is quite critical of the RBI’s approach to inflation control. See:

http://www.business-standard.com/india/storypage.php?autono=330908

He focuses on the CPI and argues that domestic interest rates are high enough, that large firms can tap international financial markets at lower rates, that the causes of the high inflation rate are supply side factors, and that other countries are not squeezing their economies as hard.

RBI is inflating the Indian economySyed Zahid AhmadThe present trend of recession in US and prevailed uncertainty in petroleum nations had provided opportunities for India to pull funds from US and Gulf countries, but the practical approach of RBI has converted these opportunities into challenges as the liquidity and inflation is certainly not under control of the RBI, who attempts to freeze the liquidity by increasing the interest rate. Costlier credits due to increase in interest rate increases the cost of output, and also creates shortage of supply. It increases the price level further up. However the interest expended over deposits inflates the purchasing power of depositors which helps inflation growth. FICCI and the corporate sector have already disagreed with RBI recent announcement to increase the rate of interest.With recent trend of increased capital inflow into India the aggregate deposits by Scheduled Commercial Banks (SCBs) has increased from 80.7% in 2005-06 (Rs. 21,09,049 crores) to 102% (Rs. 31,96,939 crores) of GDP at factor cost by 2007-08. With increased deposits, the bank credits has also increased from Rs. 15,07,077 crores in 2005-06 to Rs. 23,61,914 crores by 2007-08 reflecting 75.6% of GDP at factor cost in 2007-08 as credit against 57.7% in year 2005-06. This indeed is a point of time, when our economists, financial sector regulators and bankers need to review the policy and practices adopted by RBI as we use interest as a major tool to control liquidity; but we hardly evaluate the multi tier effects of interest in our economic process. On first tier increase in interest increases the cost of credits which increases capital cost; on second tier the costlier capital pushes the prices of output produced which results to inflation. With increase in inflation, the increase in wages and salaries are bound to increase the factor cost of production as third tier which ultimately further increases the price level at forth tier. Thus an increase in interest rate causes a multi tier effect in inflating the economy.Our net real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. The liquidity theory of J. M. Keynes is failed here to guide RBI optimize these opportunities. The practical approach of RBI to curb the rate of inflation by increasing the rate of interest may not control inflation and might lead towards stagflation as the prices are continue to increase along with purchasing power of the depositors, but the expenditure, investment and net GDP growth rate is falling due to costlier credit and interest based deposit schemes.By increasing the rate of interest, liquidity might be controlled for shorter period, but with increased cost of credit, the GDP value will increase that leads to inflation. Interestingly the interest income to SCBs was Rs. 1,85,384.9 crores in 2005-06 which increased to Rs. 2,37,271.14 crores by 2006-07. It means by 2006-07 total interest income to SCBs was 7.1% of GDP at factor cost. It simply means that the interest income to SCBs has inflated the value of GDP at factor cost by 7.1%.With increase in rate of interest, the aggregate deposits might increase and SCBs may need to pays more interest over increased deposits. Total Interest expended by SCBs over deposits was Rs. 89,742 crores in 2005-06 which increased to Rs. 1,20,261.08 crores by 2006-07 showing a net annual increase of 34%. This growth is inflationary as it increases the buying capacity of the depositors. By 2006-07, the interest expended over deposits was around 4.20% of GDP at factor cost.If we add the interest income of SCBs to interest expended over deposits, it stands for around 12.5% of GDP at factor cost and 8.6% of GDP at market prices in 2006-07. Considering the impact of interest on inflation, we may need to add interest income of SCBs through investments / commercial credits with interest expended by SCBs over deposits. This amounts to approximately 9% of GDP at factor cost and 5% of GDP at market prices in the year 2006-07 while annual rate of inflation was 6.7%. It reflects that basically inflation is a result of interest charged on credits expanded by SCBs and interest expended over deposits. The interest charged by SCBs increases the cost of GDP and the price levels, while the interest paid by SCBs over deposits increases the purchasing power of the depositors. Both ways the interest is increasing the price level and causing inflation. Since RBI regulates the banking business in India, by increasing rate of interest it is increasing the inflation and decreasing the real term growth rates.Further to note that RBI is increasing the rate of interest for over one year to control the inflation which ultimately increasing the cost of GDP showing higher GDP value and increasing inflation instead of controlling it. Our total final consumption expenditure as % of GDP at market prices is already declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. This economic tendency may leads to stagflation which is more dangerous for economic stability and growth. RBI should review its policies and practices to monitor liquidity, credit and inflation, if we have to combat inflation and attain desirable growth rate.Often it is argued that inflation devaluates the money and interest over deposits compensates it’s money value, but this argument is missing to note the cruel problem of inflation which arises due to interest and could worse of with more interest over deposits. Islamic economic ethics suggests mechanisms for stable and anti inflationary monetary system which should be adopted by RBI to make our monetary system more stable and anti inflationary. Hope the RBI will consider these ethics as measure to combat inflation and stagflation. Islamic Banking principles and practices will not only increase the equity deposits and finances but also promote capitalization and investments. It will help increase employment and business opportunities which are must for inclusive and foster growth of India at a time when world is eying upon Indian economy for making more investments. Otherwise consistent approach of RBI to control inflation through interest rate may let the UPA government face cruel failures in capitalizing the investment and growth opportunities with worst off inflation and stagflation.Wish all the best for Indian economy, the general Indians, RBI and the UPA government.

Since the following texts have beedn deleted from the original article by Syed Zahid Ahmad, the readers are requested to kindly not consider these texts as part of hsi article.”Our real term GDP growth rate (= GDP growth rate at factor cost – rate of inflation) has considerably declined from 5.2% in 2005-06 to 2.9% by 2006-07 and fell down to 1.6% by 2007-08. As the interest increases the cost of credit and output, even the GDP value is inflated through interest. Thus the higher GDP growth rate like 9% just reflects 1.6% real term GDP growth rate if inflation rate is 7.4%. “