Decisive moves

RBI Governor D. Subbarao has announced a sharp change in monetary policy,to tightening,with a clear anti-inflationary stance. This is welcome in an environment where the inflation rate has been persistently moderately high,without showing signs of going down on its own. Two years ago when inflation started rising in India,in contrast to the rest of the world,there was confusion on how to deal with it. Today,for the first time,in a clear and firm voice the RBI has announced its commitment to fight inflation. The stance of monetary policy is not defined merely by a change in the repo rate,but also by the increase in the savings deposits rate,the increase in provisioning and the reduction in the expected GDP growth rate.

This change has been long overdue and perhaps has come too late to impact inflation quickly and decisively. In that case the RBI has indicated that it will continue to fight inflation,which means we are likely to see rate hikes. The governor held that a low and stable inflation rate was necessary to create certainty about the investment environment and is needed to see greater capacity-building. Since India has seen little addition to capacity after 2008,today growth will come not by increasing short-term demand,but by higher investment. The change in the monetary policy framework to a 200 basis point corridor in which banks can borrow from the RBI and lend to the RBI; the move to a single instrument,the reverse repo rate; and to a single intermediate target in the liquidity market,the weighted call money overnight rate,will improve the working of monetary policy.

The next change the RBI needs to make is to move away from the WPI to the CPI as the measure of inflation on which it focuses. Since the CPI is the rate that affects the lives of people,it is what matters,especially in creating wage-price spirals and inflationary expectations. The RBIs policy is a clear and welcome step in the right direction. After denying the role of monetary policy in inflation depending on what is causing inflation the present communication strategy suggests that regardless of what is the cause,controlling inflation will be the guiding objective of the RBI. If the RBI continues to give this strong message,inflationary expectations should hopefully come down and as monetary policy transmission takes place over the next two years,we will see lower inflation.