It is either inflation or exchange rate

Financial Express, 24 April 2010

RBI raised the repo, reverse repo and the CRR by 25 basis points each. With this the RBI has given a clear indication to markets that it will not tolerate higher inflation. However, if RBI's actions on the currency market are inconsistent with tighter monetary policy, this policy move will not be successful in controlling inflation.

Higher policy rates impact upon inflation mainly through the `bank lending channel' and the `exchange rate channel'. The RBI and government now need to ensure that these channels work efficiently so that inflation is conquered and further rate hikes are not required. If these channels do not work it will require rates to be raised much more sharply than the RBI may like to. For some time banks have faced relatively low demand for credit. But as industrial growth picks up and the demand for credit rises, higher policy rates and higher CRR imply that bank credit should become more costly. Higher interest rates would keep the demand for credit in check. At present, all banks may not raise interest rates immediately. If the RBI continuing on the path of tightening, soon one could see a situation when banks raise lending rates.

The second channel though which higher interest rates restrain inflation is through the exchange rate channel. Monetary policy in the US and Europe is likely to remain loose for some time to come. A hike in interest rates in India pulls in capital inflows by increasing interest differentials with the rest of the world. This would help the rupee to strengthen. A stronger rupee would reduce the price of tradables, and offset some of the global tradeables inflation. These are primarily the non-food items which shape the `core inflation' that RBI has been most worried about. The pressure on higher prices both in the local economy and with global tradeables is thus partly offset through a policy of higher interest rates and thus a stronger rupee.

RBI Governor D. Subbarao has said in some post-credit policy interviews that RBI is not using rupee appreciation to control inflation. Regardless of what the intent may be, a strong rupee does help in containing inflation. If, alongside raising rates, the RBI gets into trading on the currency market in order to force a strong dollar, that would be inconsistent. This would drive up the price of tradeables. This will result in higher WPI manufacturing inflation, and then put pressure on the RBI to hike rates further, thus revealing the lack of consistency of that policy mix. In addition, controlling liquidity will become difficult if the RBI buys dollars to prevent appreciation. Policy could then collapse into trying to do capital controls to prevent inflows, creating further distortions in the market and setting off a fresh trouble for RBI.

In recent days RBI has reopened the MSS window. This suggests that they have either started buying dollars or plan to buy dollars. As argued above, this would be an inconsistent policy platform, and yield a mess (as has been seen in previous years when RBI tried to prevent rupee appreciation).

In the present environment, when politicians are focused on the inflation rate, RBI must clear say to the government and to the larger public that it cannot simultaneously fight inflation and achieve distortions to the exchange rate. The RBI itself does not face pressure from lobbies, but the government does. The resolution of this conflict is a political decision. It is when such conflicts arise that central banks have been able to make their life easier by adopting inflation targeting as their objective. If the government wishes to support exporters, then instead of doing it through exchange rates that distort monetary policy and prevent RBI from successfully attacking inflation, government should do it through direct subsidies. Former Finance Minister P. Chidambaram once pointed out that MSS interest payments, which have amounted to more than Rs. 3000 crore a year in the past, are an export subisidy. Instead of such a subsidy, which simultaneously distorts monetary policy and induces high inflation, exporters should be given a direct on-budget subsidy.In summary, RBI's move on tightening monetary policy will only be effective if it is accompanied by a strong rupee.

The good news might be that thanks to the slowing down in food price inflation, inflation could stabilise to 6-7 percent by July. Higher food prices can spill over into higher inflation by pushing up the CPI and thus putting pressure on wages to rise. Rising input costs, both due to higher commodity prices and due to higher wages, can lead to a second round effect on inflation. But with a lower base effect, a stronger rupee and some tightening, it is hoped that over the next two months inflation rates would stabilize. However, there may be further hikes, perhaps even before the next credit policy, if inflation and growth numbers remain high. RBI seems to be in a mood to wait, watch and move rates slowly rather than to move them in big moves. This bodes well.

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