A study by C. Rangarajan and K.R. Shanmugam reveals that India's money supply (M3) growth is a more reliable predictor of inflation than repo rate changes. For investors, this implies that liquidity management is as crucial as policy rates for price stability, and tracking both may offer a better view of future inflation trends.
Most investors closely track the Reserve Bank of India’s (RBI) repo rate to gauge the direction of inflation. However, recent economic research by C. Rangarajan and K.R. Shanmugam suggests that the volume of money in the economy, known as money supply, might be a more accurate indicator of inflation than interest rates alone. This insight shifts the focus from simply looking at borrowing costs to understanding the actual amount of cash circulating within the system.
Traditional monetary policy often relies on increasing interest rates to make borrowing expensive, which aims to cool down demand and lower prices. The study, which analyzed Indian economic data from 1994 to 2024, points out that while rates are important, the expansion of money supply—specifically broad money, or M3—has a tighter correlation with the Consumer Price Index (CPI). When the volume of money circulating increases without a corresponding rise in the production of goods and services, prices tend to rise regardless of where the repo rate stands.
For investors and market participants, this distinction matters significantly. If the central bank views interest rates and liquidity management as two sides of the same coin, policy decisions might become more focused on controlling excess liquidity. This could mean more frequent use of tools like Open Market Operations (OMO), where the central bank buys or sells government securities to manage the cash available to banks, rather than relying solely on changes to the policy rate.
Understanding this relationship is important because inflation directly impacts corporate profitability. High inflation often forces companies to deal with higher raw material costs, which can squeeze profit margins if they cannot pass those costs on to consumers. Furthermore, if liquidity management becomes a primary tool for curbing inflation, interest rate cycles may behave differently than historical patterns suggest. Investors keeping an eye on both the repo rate and system liquidity indicators—such as the banking system's daily surplus or deficit—could gain a clearer picture of how monetary policy might evolve.
The authors conclude that for true price stability, there needs to be better synchronization between liquidity actions and interest rate objectives. Moving forward, the effectiveness of controlling inflation will depend on whether central bank policies successfully combine these levers to match real economic demand.