Taming inflation is the unambiguous objective for the Reserve Bank of India (RBI) in setting its annual credit policy. Clear though the choice is, the path is complex. Withdrawing the monetary tube with the economy still on the monetary-fiscal inhaler could leave the patient gasping. Yet the danger of intoxication from the heady cocktail is rising. Amid all this, the central bank must chalk out a nuanced incline. The choices are: bring down the sledgehammer, stick to the “baby-step" approach, or accelerate the pace a bit.

Illustration: Jayachandran/Mint

The case for normalization is persuasive. Recent industrial production data confirms a shift in growth drivers towards capital goods; this is buttressed by an average 45% import growth in the last three months. Interpreted differently, this means private investment demand is now supplementing private consumption and public investment. The highest corporate earnings growth in many quarters—pegged above 20% year-on-year (y-o-y)—with improved quality, broadened base and free cash flows, implies firms are in capacity expansion mode. The labour market—an average 12% wage increase complementing hiring—adds further conviction to the recovery. Throw in the finance minister’s assertion of at least 8.75% real gross domestic product (GDP) growth in 2010-11, and there’s a brew of optimism about the future. Indeed, some coals on the stove—cement, iron and steel, auto, some services, widening current account deficit—are even turning red. The exceptional circumstances that prompted the ultra-easing have all but melted away.

Clouding this picture is inflation. Food price drivers are now joined by core price pressures, which have driven 50% of the overall price increase since January. March data suggests headline inflation has peaked. The seasonally adjusted y-o-y Wholesale Price Index inflation is a tad lower than February at 9.9%, but the relevant point for monetary action is core inflation (excluding food and energy) at 4.7%. Upside risks ahead suggesting pre-emptive tightening are: a surge in global commodity prices, suppressed domestic fuel prices, high capacity utilization rates and strong demand.

The monetary stance is thus super loose relative to the economic cycle. Real policy rates are negative even vis-à-vis core inflation. The threat of inflation expectations getting persistent is real. There is little statistical guidance to expectations, but the sharp deceleration in time deposits’ growth and the behaviour of monetary aggregates tell a story. M1—narrow money (currency in circulation plus demand deposits)—growth is accelerating since June. It’s outpaced broad money, or M3, growth—this adds time deposits to M1—since December.

When M1 grows faster than M3, it usually means money balances are shifting from time deposits, or savings, to current accounts and cash with the public (also known as “dissaving"). This means money is being spent instead of remaining with the banks: a good thing, no doubt, as consumers and producers resume spending after the slowdown. But the fear of rising prices could also be driving this shift; real returns fall and consumers buy now, than later, to get more bang for their buck. In an inflationary environment, there is also the risk of surplus cash aggravating further price increases of not just goods and services, but also financial assets such as property and stocks.

It’s uncertain how good a proxy of households’ inflationary expectations this metric is, but at least two recent inflation episodes—August 2002-May 2003 and October 2007-July 2008—were marked by slowing time deposit growth and widening M1-M3 growth gap. A recent International Monetary Fund paper (by RBI staffers M.D. Patra and P. Ray) identifies the real interest rate—a measure of returns and also the monetary stance—has the most significant impact upon anticipated inflation, overshadowing fiscal policy and exchange rate change.

Banks have already responded by offering higher deposit rates. Acceleration in private credit demand—the aggregate credit-deposit ratio reached 72.2% this March (Sonal Varma of Nomura points out that the incremental credit-deposit ratio shot up to 138.2%)—and regulatory changes from April will push up deposit rates higher. Narrowing spreads, in turn, will pressure lending rates upwards.

RBI has to respond quickly to these developments or it risks losing credibility. This calls for acceleration in the exit from the exceptional stance. Policy rates need to be in the 4-4.5% range for neutralization alone. Yet an increase in policy rates is likely to be ineffective in the current scenario of abundant liquidity. And fiscal policy constrains RBI from shifting to deficit mode and reversing the policy rate.

Within these bounds, RBI can only signal a strong commitment to price stability, without any meaningful tightening. How would this be?

It is likely RBI will aggressively cut liquidity through a half percentage point increase in the cash reserve ratio (CRR). This would remove approximately Rs225 billion (Rs22,500 crore) of liquidity from the system. Daily absorption averaged Rs877 billion in the first half of April, rebounding to February levels after the 75 basis points CRR hike. Plus, foreign capital inflows are expected to remain while sharp rupee appreciation suggests intervention-cum-sterilization will augment money supply. This will ensure smooth conduct of bond auctions, the sole consideration for liquidity drainage at this point.

It will also lay the ground for a real tightening later. There’s an opportunity now to realign overnight rates somewhat through a 50 basis points increase. Will RBI bite the bullet? The caveat between a 25 or 50 basis points hike in policy rates would be RBI’s caution: not to disrupt the nascent investment cycle and shock with its aggressiveness.

Renu Kohli was, until recently, with IMF. Comment at theirview@livemint.com