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Yesterday (27-Oct-09), the Reserve Bank of India raised the Statutory Liquidity Ratio (SLR) of Banks by 100 basis points to 25 %. This, the RBI said was being done to curtail the ever increasing Inflation. The RBI also hinted at raising the Cash Reserve Ratio (CRR) in the future.

But, Hey!!! Wait a sec. Didn’t we have a negative inflation just a month back? Didn’t we see all past records being broken as the inflation touched a 33 year low?

And, even presently our inflation rate is a mere 1 odd percentage point. Then why is the RBI so    worried about the  inflation? And why is it raising rates and in doing so sending the stock markets into  bit of a tizzy?

Truth is, the negative or low inflation is a MYTH and there are multiple reasons for it.

Almost a year back during this time, Inflation in India had touched a 16 year high of 13%. And if you are someone who visits the super-markets frequently you would have noticed that the price of articles haven’t reduced but have in fact sky-rocketed in recent times. Food and primary article prices have increased by a staggering 25% !!!

Before we move on to find the reasons for this increase in commodities’ price lets find out what are the reasons for this misleading inflation figure.

-          Base Effect: Inflation isn’t an absolute but, a relative figure. An inflation of 1% now means it is 1% more than the inflation last year during this time. So, if inflation during this time last year was 13%, the actual inflation currently is 13+.

-          India is amongst those very few countries which uses the Wholesale Price Index (WPI) to measure it’s economic inflation as against the Consumer Price Index (CPI). This gives us a very wrong idea of the actual inflation faced by the consumers.

Now, lets see what is the reason behind the spike in food prices?

-          Globally, the price of commodities are at an all time high. No doubt, India isn’t insulated from it.

-          To add fuel to the fire, we didn’t have a good monsoon either which has adversely affected the Rabi and Kharif crops.

-          In order to tackle recession, the GOI eased the interest rates from 9% to 3% last year. By doing so the liquidity or money increased in the system. Demand increased, Supply decreased. Inflation and price of commodities just followed the law.

So, surely the problem in hand is a serious one and has to be tackled with great care.

What is the Government of India doing about it?

-          RBI has started with increasing the SLR as mentioned in the beginning. Basically, the idea is to suck out the excess liquidity in the system. RBI will be raising the CRR in the future too. (Basically, the rates will increase > Banks will have less money to lend > People and Institutions will have less money to borrow >  Demand will decrease due to less liquidity > Inflation will stabilise).

But, the task is not as easy as it seems. The government definitely has to keep the inflation in check but, will it do so by compromising growth? Already, the GDP forecasts have been downgraded to 6% levels. Tightening rates would mean slowing down growth and slowing the recovery during the ‘beginning of the end of recession’.

Needless to say, we are caught in a vicious cycle.

Pranab Mukherjee, Finance Minister of India and Dr Subbarao, the Chairman of RBI has a tough task at hand.

The Microreviews team wishes them all the best. And ya, we will be keeping a close eye on the Macro-Economic picture of India and the path it treads in the future.

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