Focus on inflation, not growth

Focus on inflation, not growth

In 2008-09, the Reserve Bank of India’s (RBI) primary task at hand was to protect the Indian financial system from the impact of the global financial meltdown, and it did so remarkably well. In the second half of 2009-10, this changed from managing a crisis to managing an economic recovery. This the bank achieved initially through the withdrawal of monetary accommodation for certain sectors; subsequently by a hike in banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks are required to keep with the central bank; and finally, by effecting an increase in policy rates.

As the recovery gathers momentum and becomes more broad-based, the Indian central bank’s task in 2010-11 has shifted from managing a recovery to managing inflationary expectations. This is the central theme of RBI’s review, Macroeconomic and Monetary Developments in 2009-10, released a day ahead of its annual monetary policy.

RBI’s survey of professional forecasters has pegged the growth rate in 2010-11 at around 8.2%, a full percentage point higher than the estimated growth in 2009-10, and much above the 6.7% growth achieved in 2009. But the biggest risk to the growth story is rising inflation. Many analysts believe that wholesale price-based inflation peaked at 9.9% in February, and RBI, too, seems to believe so as the review says inflation could be expected to moderate in the next few months. The central bank’s inflation projection will be part of its annual policy document. What is worrying is non-food manufacturing inflation. This was negative up to November 2009, but has risen to 4.7% in March.

The other critical factor that will influence the stance of RBI’s monetary policy is rising asset prices. A strong economic recovery and easy money, available globally, may lead to higher capital flows which, in turn, will lead to appreciation of the local currency as well as asset prices.

Given this background, RBI’s task for its annual monetary policy is cut out: It can’t afford an asset bubble and, more than fighting inflation, it must try to anchor inflationary expectations. The twin purposes can be served only if it hikes both its policy rates as well as CRR in its annual policy.

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