With no credit

A spectre is haunting the RBI,the spectre of inflation. The month-on-month seasonally adjusted WPI inflation is hovering around 15 per cent. Some of this is food the WPI inflation is running at 20 per cent by the same measure but a lot of it is non-food inflation. But what choices did the RBI have to make a difference? Decades of policy mistakes on the bond market and on banking have resulted in an ineffective monetary policy transmission. Increasing or decreasing the interest rate does not seem to impact inflationary pressures. The size of impact is not statistically discernable from zero. The central bank is a spectator when it comes to using the short-term rate to deliver low and stable inflation.

The debate will continue on the RBIs decision to raise the CRR but the honest truth is that this just does not matter. How,then,can inflation be checked? There is a short-term strategy and a long-term strategy. The short-term strategy should focus on two issues. The first is food prices. Indian agriculture has been ill-served by policy blunders,particularly in the recent past. Fresh thinking is needed on an array of policy issues in agriculture. The second lever which can work in the short-run is the exchange rate. Unlike the short-term interest rate where the measurable impact on prices is zero the exchange rate matters. There is a visible and measurable impact on prices: when the rupee appreciates,this tames domestic inflation,and vice versa. To some extent,the inflation we are seeing today is the delayed reaction to the sharp rupee depreciation of previous months. The RBI document reflects concern about capital inflows. This betrays a lack of understanding of the relationship between capital inflows,the exchange rate and inflation. The right strategy for the RBI today is to continue with liberalisation of the capital account,so as to encourage capital inflows. This would yield rupee appreciation and thus combat inflation.

Politicians are right to be highly concerned about inflation. The only useful thing that monetary policy can do to assist Indias long-term growth opportunities is to deliver stable inflation. In the short run,this requires new thinking on agriculture and on capital account liberalisation. In parallel,the three reports led by Percy Mistry,Raghuram Rajan and Jahangir Aziz outline the path for India to get a plausible financial system,where the RBI can deliver low and stable inflation through control of the short-term interest rate.