Stable Interest rate and Exchange Rate and Inflation...

The Indian economy has been under pressure, on the monetary policy and interest rate fronts, despite low inflation, partly attributed to low food prices, but inflation expectations had been on the upside due to pick in fuel prices since March 18.

Nonetheless, they have been on a down trend after October which has considerably altered the expectations about inflation and chances of an accommodative central bank if inflation remains within the target in a world of low real interest rate that has affected the supply side in INDIA even in the face of less than full employment situation and when exports failed to increase inspite of depreciation in the exchange rate that has also contributed to inflation because of higher oil prices and foreign exchange price.

Recently, INDIA leaped unprecedently in the World Ease of Doing Business rating from 100^th to 77^th from last year which could mean a lot to international investors support by the demographic dividend and huge demand and supply conditions even though there is an outflow of foreign capital from the debt and equity markets in the country owing to inflation and depreciation and higher interest rate and expectations which could be averted through a prudent interest rate and foreign exchange rate management.

Nonetheless the RBI attempted to supply more dollars to rein in depreciation, but that deteriorated the rupee liquidity position that aggravated the outflows from the debt market when interest rate in the recent started hardening which negatively affected the bond prices and outflow of foreign capital further increasing the depreciation, all due to higher inflation and interest rate expectations. 

The exchange rate management is an important tool to control inflation through exchange rate targeting which could help achieve price stability when INDIA imports 80% of its oil needs and is a major source of inflation in the economy, notwithstanding lower inflation and interest rate could also help boost exports against depreciation that increases domestic inflation and lowers real incomes and demand and growth.

Moreover, higher interest rates could not let exports materialize, therefore a policy that aims to boost productivity and lowers inflation and interest rate and expectations might help increase competitiveness than just lowering exchange rate which increases domestic inflation and interest rate and expectations by increasing the price of imports, lower inflation could also increase real incomes and real exchange rate and demand, domestic, imports and exports and growth .

The one thing the government needs this time is a prudent foreign exchange rate management to wither the effect of higher oil prices and its effect on domestic inflation and interest rate and expectations which have given rise to higher interest rate and expectations...

Targeting a strong exchange rate to lower the effect of depreciation on higher oil prices could help improve domestic inflation and expectations and lower interest rate and expectations...   

Stability in the interest rate and exchange rate regimes and movements in narrow bands would also help stabilize domestic investment and expectations, and, foreign investment and expectations, the capital account, and exports, the current account...

The stable or neutral interest rate is to put the point that, both, too much tightening or loosening give rise to loosening or tightening later which are also self reinforcing means inflation would signal inflation expectations and higher interest rate and lower employment and supply further increasing inflation and would create unemployment and deflation would foster deflation expectations and lower interest rate expectations and increase employment and supply and lower prices, again, if the economy is below full employment.

Therefore, to promote stable growth it is important that interest rate and exchange rate remain stable within bands at full employment without creating inflation or deflation and expectations...

After full employment higher wages would itself control demand for labour and wage inflation through market, any attempt to increase cost of borrowing would further increase cost and inflation, in the short run...

The cost of capital is a major cost of production and supply, but the Central Banks fail to recognize it and do not include the price of capital in their inflation indices and forget that lower borrowing prices could also help to lower inflation when employment and demand are the problems...

When they increase the borrowing price they forget that they reduce both demand and supply or employment and investment which further increase price and interest rate and expectations, too...