The increase in CRR and repo rates by the RBI on Friday will further squeeze available credit in the market and make loans more expensive for businesses and households. The latest move to tighten liquidity will of course be justified by citing inflation. The hike in CRR will suck Rs 15,500 crore out of the system in one day. This sledgehammer approach is disruptive for real and financial sectors. Combined with messy conditions in the money market and currency market, these events show an intellectual failure on part of the RBI in crafting a sound monetary policy for an open economy. The essential failure lies in the lack of a sound framework. At first, when the inflation as measured by the consumer price index for industrial workers (CPI-IW) crept up from levels of 3 per cent, the RBI did nothing. This was wrong, because monetary policy needs to anticipate future inflation and act well ahead of time. India has been witnessing a growth rate of 27.5 per cent in bank credit for the last 5 years, and CPI-IW inflation has edged up steadily from 2004 onwards. Net of inflation, interest rates have dropped sharply, fuelling an economic boom and some inflation. When the RBI did swing into action, a key mistake was the use of CRR, which is a blunt quantitative instrument. In mature market economies, the CRR is zero and is never used in directing monetary policy. Using the CRR and higher interest rates, the RBI inflicted pain on the local economy. This was compounded by the RBI’s handling of the currency. It kept buying dollars in the process of manipulating the rupee-dollar rate. This pumped rupees into the system and negated the effects of the domestic tightening. The RBI was inflicting pain on the local economy through higher rates, but the net effect on inflation was absent owing to the RBI’s currency trading.The RBI today has a credit policy and short-end interest rates that are changed in full public view, and a currency policy that is implemented in secrecy and that has done the opposite thing. The RBI needs full transparency about all actions, ie daily disclosure of currency trading. Such transparency would have revealed the mistakes of policy to the general public well ahead of time, and helped correct these mistakes before matters blew out of proportion.
