A creditable policy

The credit policy for the second half of the year will be announced by the RBI governor, Y. Venugopal Reddy, on October 26. Given the way prices are rising should Reddy rein in inflation by raising interest rates? One argument in favour of raising interest rates could be that monetary policy was expansionary in the last couple of years. This has led to an overhang of liquidity in the system. With inflation inching up to nearly 8 per cent, the RBI may follow the recent CRR hike with a rise in the repo rate.

But such a hike may put the incipient investment recovery in danger. In fact, in 1996 an almost identical situation had occurred. The RBI had responded to the inflow of foreign capital in 8217;94-8217;95 by massive intervention in the foreign exchange market to prevent the rupee from appreciating. This had led to a sharp rise in money supply and an increase in the inflation rate. The RBI responded by raising interest rates through various direct and indirect measures. The result was a sharp rise in borrowing rates and a steep decline in investment and industrial growth. While the decline in investment may have taken place in any case due to various other factors, the sharpness of the decline can be attributed to the steep rise in the cost of capital. The rise in inflation in the last few weeks is reflected mainly in WPI numbers, which the government admits is not the correct figure to look at. It should, therefore, not give rise to a knee-jerk reaction of raising interest rates. It is not clear that this would contain inflation which is also due to supply side factors and a rise in international commodity prices. Also, it is dangerous to put the incipient investment recovery at risk. The UPA government cannot afford to take that risk any more than it can risk higher inflation.

This dilemma points to the fact that monetary policy cannot be conducted in the old-fashioned way more suited to a closed economy. If the RBI continues to manipulate the exchange rate, it will be at the cost of losing control over monetary policy. The government faces a dilemma today because of RBI8217;s obsession with controlling the volatility of the exchange rate. The framework of an open economy necessitates that if we want to control domestic interest rates, we will have to give up control over the exchange rate. It is not too late for the RBI to learn this lesson. With a team of economists heading the government, this is the most opportune time for India to sort out complex issues of macroeconomic policy, rather than engage in knee-jerk reactions.