November - 2024

Contents
Inflation + MPC .................................................................................... 2

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Inflation + MPC

Inflation
Inflation is defined as the rate at which the general level of prices for goods and services rises, leading
to a decrease in purchasing power. It reflects how much more expensive a set of goods and/or services
has become over a specified period, typically measured monthly, quarterly and annually. In India,
inflation is primarily tracked using the Consumer Price Index (CPI), which measures retail inflation by
collecting data on the prices of a fixed basket of goods and services consumed by households.
The CPI basket in India includes 448 items in rural areas and 460 items in urban areas.
Headline Inflation Vs Core Inflation
• Headline inflation refers to the total inflation figure that includes all items in the Consumer Price
Index (CPI), such as food, energy, and other commodities. It reflects the overall price changes in
the economy and is often seen as a measure of the cost of living.
• Core inflation, on the other hand, excludes certain volatile categories from the CPI, specifically
food and energy prices. By removing these components, core inflation aims to provide a clearer
picture of the underlying long-term trend in inflation without the noise created by short-term
price fluctuations. This measure is particularly useful for policymakers, as it helps them
understand persistent inflation trends that are more indicative of broader economic conditions.
Interest Rates and Inflation Dynamics
• Rising Inflation: When inflation rates increase, central banks typically respond by raising interest
rates. Higher interest rates increase the cost of borrowing, which tends to reduce consumer
spending and business investment. As demand for goods and services decreases, price pressures
are alleviated, helping to bring inflation down. This is a contractionary monetary policy aimed at
controlling overheating in the economy.
• Falling Inflation or Deflation: Conversely, when inflation is low or there is a risk of deflation,
central banks may lower interest rates. Lowering interest rates makes borrowing cheaper,
encouraging consumers and businesses to spend more. This increased demand can help
stimulate economic activity and push inflation back toward target levels
Interest Rates and Domestic Currency
• Purchasing Power: Higher inflation erodes the purchasing power of a currency, leading to a
depreciation in its value. As prices rise, each unit of currency buys fewer goods and services,
making the currency less attractive to investors. Conversely, lower inflation can strengthen a
currency by enhancing its purchasing power, making it more appealing for foreign investment.
• Interest Rates Influence: Central banks often respond to high inflation by increasing interest
rates to control price stability. Higher interest rates can attract foreign capital, supporting the
currency's value. However, if inflation is significantly higher than in other countries, it may still
lead to currency depreciation despite higher interest rates.
Inflation and Bond Yields
• Real Returns: Inflation negatively impacts the real returns on bonds. When inflation rises, the
fixed interest payments from bonds lose purchasing power. For example, if a bond yields 4% but
inflation is at 3%, the real return is only 1%. As a result, investors demand higher yields to
compensate for this inflation risk, leading to an increase in bond yields.

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• Price Dynamics: When inflation expectations rise, bond prices typically fall because new bonds
are issued with higher rates to attract investors. This inverse relationship means that as yields
rise (due to inflation), existing bond prices decrease
RBI's Management of Inflation
The Reserve Bank of India's (RBI) Monetary Policy Committee (MPC) plays a crucial role in managing
inflation through various monetary policy tools. The MPC's primary goal is to maintain inflation within a
specified target range while supporting economic growth.
India's Inflation Targeting Framework
India's current inflation targeting framework was formalized in 2016, setting an inflation target
of 4% with an upper tolerance limit of 6% and a lower limit of 2%. This framework mandates that if
inflation deviates from this target for three consecutive quarters, the RBI must report to the government
explaining the reasons and corrective measures.
The framework emphasizes maintaining price stability as a primary objective while considering
economic growth.
Monetary Policy Committee (MPC)
The MPC was established under the amended (Section 45ZB) Reserve Bank of India Act, 1934, to
enhance transparency and accountability in monetary policy decisions. It consists of six members:
• The Governor of RBI (Chairman)
• Three members appointed by the central government
• Two members from the RBI. The Deputy Governor heading RBI’s Monetary Policy Department is
the ex-officio member, while one officer of ED rank is another member.
Formation and Mandate
The MPC was formed following recommendations from the RBI-appointed Urjit Patel Committee in
2014 aimed at modernizing India's monetary policy framework. Its mandate includes:
• Setting the benchmark policy interest rate (repo rate) to achieve the inflation target.
• Conducting at least four meetings annually to assess economic conditions and adjust monetary
policy as necessary
MPC Stances
The MPC can adopt various stances based on economic conditions:
• Accommodative Stance: Aims to support economic growth by keeping interest rates low.
• Neutral Stance: Maintains current rates, balancing inflation control and growth.
• Tightening Stance: Increases interest rates to curb rising inflation.
These stances are determined based on current macroeconomic indicators, including inflation trends
and economic growth projections.
Rate Cut Cycles
Rate cut cycles can be shallow or deep, depending on the circumstances:
• Shallow rate cut cycle: These cycles can reflect periods when inflation is a concern, but the labour
market and economy are strong.
• Deep rate cut cycle: These cycles can occur when the economy is slowing and a financial crisis is
looming.
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