RBI has its work cut out

RBI has its work cut out
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First Published: Sun, Apr 18 2010. 09 23 PM IST

 Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Sun, Apr 18 2010. 09 23 PM IST
The new monetary policy that is to be announced by Reserve Bank of India governor D. Subbarao on Tuesday should hold few surprises: most economists agree that the Indian central bank will have to increase its policy interest rates and perhaps bank reserve requirements as well. The only debate is about the extent of these increases.
Illustration: Jayachandran / Mint
The real interesting parts of the policy are likely to be found in the overall observations that Subbarao will make about the state of the Indian economy and the policy options available at this juncture. There are three issues that are especially important in this context.
The first issue is what effect high consumer inflation since 2008 has had on the inflationary expectations of households. It is quite likely that these expectations have started drifting up, with the corollary that wage demands could grow even as the credibility of the central bank as an inflation fighter is put under pressure. RBI surveys household expectations and we would keep an eye out for what the governor says about these trends. There could be a case for a sharp rise in interest rates in case there is empirical proof that inflation expectations have become unmoored.
The second issue that matters right now is how RBI responds to the surge in capital flows in recent months. The central bank has more or less stayed out of the foreign exchange market, refusing to buy dollars in a bid to keep down the rupee. The result is that the Indian currency has been appreciating against the dollar and is heavily overvalued going by the real effective exchange rate. A flexible exchange rate is a viable strategy for a country battling inflation, but there will surely be a point when a strong rupee will raise cries that the competitiveness of Indian manufacturers is under threat, at least till China, too, lets its currency appreciate. It will be worth seeing whether Subbarao will drop any hints about capital controls, which even the International Monetary Fund now says should be part of the policy tool kit, though it has to be wielded with caution.
The third big issue is asset inflation. India does not seem to have a full-blown asset bubble as yet, but RBI has valid reasons to worry about the pace at which equity, real estate and gold prices have risen over the past 12 months. There is an outside chance that Subbarao may announce specific restrictions to limit bank funding of mortgages and equity investment. RBI had used this option effectively in 2007 and 2008.
The Indian economy has moved from crisis to recovery very quickly—but could be standing on the threshold of overheating too early in the business cycle.
Is it time for the central bank to put its foot down? Tell us at views@livemint.com
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First Published: Sun, Apr 18 2010. 09 23 PM IST