Inflation is in the news. The latest figure puts it at a two-year high of 7.51 per cent. Rising world oil prices have put pressure on prices all over the world. But why are inflation levels in India higher than elsewhere? The price rise is not simply the effect of higher costs as a result of higher fuel prices. It is not limited to a few items in which there are acute shortages. It is a broad based phenomenon. Also, this phase is not going to be over soon. Even in the unlikely event of global oil prices not rising further, India may continue to see inflation above 6 per cent. Ironically, the RBI is hanging on to its inflation forecast of 5 per cent. Given that inflation in the first four months of the year has been higher, this means that it must go down later to achieve this average. But the RBI’s policies in the last two years may make this target impossible to attain. Since June ’02, the RBI’s policy of manipulating the rupee created expectations of rupee appreciation in foreign exchange markets. This led to a sharp inflow of foreign capital and intervention resulted in a buildup of foreign exchange. The increase in foreign exchange reserves was sterilised to some extent, but the sterilisation was partial. The result was an expansion in the monetary base in relation to GDP. This expansionary monetary policy has led to a build up of liquidity in the system. Evidence of this is the decline in interest rates observed in the last two years. Will the RBI tighten monetary policy, as is being done by the Fed and the Bank of England? They have raised interest rates. But raising interest rates is not going to be an easy decision for the RBI. On the one hand, higher interest rates are going to hit the balance sheets of banks that have large interest rate exposures. On the other, the RBI — as the government’s banker —tries to keep rates low, so that the interest bill of the government remains in control. The objective of monetary policy to control inflation may take a backseat in the face of RBI’s role as the banking regulator and the government’s debt manager. Unlike the Bank of England, whose sole job is to conduct monetary policy, the RBI may have to put its dharma of inflation control on hold. If India’s economy is not to be forced to bear the cost of higher inflation, it is important that the RBI is freed of its other obligations. The RBI Act of 1935 needs to be changed to allow the RBI to create a stable environment for growth and low inflation.
