Rupee the new inflation-fighting tool?

Given its constraints on the monetary policy side, where it has to keep interest rates low to give a fillip to economic activity crippled by Covid-19, it cannot raise interest rates to fight inflation. So, it has found a tool in currency.

Inflation has been above the target prescribed by law to the Monetary Policy Committee. Given the price pressures, the market has been demanding that interest rates be pushed higher. With yields rising more than 30 basis points in a matter of days, it’s tough even for a central bank. A basis point is 0.01 percentage point.

The RBI has so far been absorbing the capital flows to prevent the appreciation of the currency, taking foreign exchange reserves to a record high which the Bank of America forecasts to touch 550 billion dollars.

The Rupee has appreciated 3.6 percent this fiscal despite RBI’s dollar purchases. The RBI net bought $14.2 billion in the June quarter. Foreign exchange reserves are near a record at $537.5 billion, up $108 billion from a year earlier.

As the RBI battled to keep exports competitive by preventing a sharp Rupee appreciation, it let more Rupee into the system fuelling inflation, which is also being caused by the dislocation in supply chains.

This brings to fore the difficulty of managing interest rates, capital flows and exchange rates - what economists call the `impossible trinity.’

Given that inflation is becoming a threat and that easy monetary policy cannot be reversed soon killing a potential recovery even before it begins, the options for the central bank are limited.

Conventional wisdom has that no central bank can manage the impossible trinity and something has to give in. India needs capital so can’t halt it. RBI can’t raise cost of funds stalling a nascent recovery.

What could be compromised without provoking a public outrage is the currency management. It is easier to manage the optics when it is appreciating. So, brace for a currency appreciation as the Greenback flows in.