Raising expectations

The Reserve Bank of India has raised interest rates for the tenth time to bring inflation under control. The tone of the policy is consistent with that of the annual policy last month when interest rates were raised by 50 basis points. Immediately before the policy,numbers released showed that inflation continued to be high. At the same time,inflationary expectations continued to rise. The RBI survey showed that households expect inflation to be above 12 per cent. It was thus important to raise rates and continue with the anti-inflationary focus of monetary policy.

While the RBIs policy statement is consistent with that of the last policy,it does not have an easy job in bringing down inflationary expectations. The difficulties arising from higher fiscal deficit,the pending diesel price correction,the rise in global commodity prices and any increase in food prices pose potential sources of trouble. However,as the monetary authority,the RBI does not control these possible sources of inflation therefore,it will have to communicate to the public that inflation will not be allowed to rise to a higher trend level. When there are shocks to prices they can result in persistently higher trend inflation if the higher cost of living feeds into higher salaries and higher cost of production.

The battle against inflation will require the RBI to build credibility as an inflation hawk. Inflation has to become the prime focus of the RBI and the public has to see that and believe it. If this requires the RBI to give up all conflicting objectives which make it appear that its commitment to inflation-control is weak,then the RBI must give them up. It is difficult for a central bank to keep interest payments low for the government,as is its job as the banker or debt manager of the government especially at a time when the fiscal deficit is rising as well as be equally committed to raising interest rates to tighten monetary policy. RBI communication on all subjects should reflect its commitment to low and stable inflation. In the long run,no one but the monetary authority can be held responsible for the average medium-term inflation rate. Only consistent policy with a commitment to low inflation clearly communicated to the public will allow the RBI to deliver that low rate.