On the cutting edge

RBIs caution on rates frames the challenge of policy-making in a volatile inflation environment

RBIs caution on rates frames the challenge of policy-making in a volatile inflation environment

The RBI chose not to cut interest rates in its monetary policy announcement after a sharp depreciation of the rupee led to expectations that inflation would rise. Even though there is pressure on growth,a rate cut could have led to a reduction in the flow of capital coming into the economy. The second consideration must have been the difference between the WPI,which is now showing a decline in inflation,and the CPI,which hurts household expenses where inflation continues to be high. Over the last three months,the average month-on-month seasonally adjusted CPI inflation stood at 11.4 per cent in April,which is far from the target zone of 4 to 5 per cent. Things will become a bit worse with the rise in prices of tradables owing to the recent rupee depreciation. Right now,the prices of tradables are slumbering: the three month average of WPI non-food non- fuel stood at 0.33 per cent in May. But that will worsen in coming weeks. Hence,the RBIs inflation forecast must contain a gloomy outlook.

This is not to say that monetary policy should cater to currency stability. The rupee is a largely floating currency,the exchange rate is mostly determined by the free market,and this should continue. It should be understood that the objective of the RBI is to deliver price stability,not rupee stability. Within this basic picture,two phenomena are taking place. Higher interest rates will suck capital into India and thus support the rupee. And,rupee depreciation feeds into prices of tradables with a time lag,thus impacting upon forecasts of inflation. The RBI should conduct monetary policy looking predominantly at forecast inflation.

Looking ahead,if growth remains sluggish and pulls down investment demand,the forecast for inflation can go down. This would allow the RBI to reduce rates. However,inflation has high persistence in India and so the RBI cannot afford to cut rates and risk another round of higher inflation. The making of monetary policy is extremely challenging in a volatile inflation environment,especially if there is a danger of stagflation. Expecting large rate cuts from the RBI only looking at inflation numbers,will be misguided. The RBI will take into consideration the current account,the rupee and the GDP growth to forecast inflation,and it will then choose interest rate policy changes.