What central bank governors say is often as important as what they do. Reserve Bank of India (RBI) governor D. Subbarao has been busy sending out signals to the financial markets and companies that interest rates have bottomed out. The only question worth debating is when rates will be increased.

Subbarao will show his hand on Tuesday, when he announces his new monetary policy. The overwhelming consensus is that he should leave rates unchanged for now—a conclusion that we see no reason to disagree with. But we would also urge Subbarao to further drive home the inevitability of higher interest rates in 2010. The tone of the policy will have to be more hawkish.

Illustration: Jayachandran / Mint

This is a tricky situation. An immediate increase in interest rates as a pre-emptive strike against inflation could shatter the fragile recovery. Both Subbarao and the Prime Minister’s economic advisory council headed by C. Rangarajan have stressed the importance of confidence in the downturn and revival. Higher interest rates could damage that confidence right now.

The most important reason why Subbarao needs to focus more on supporting growth rather than fighting inflation right now is the fiscal deficit. Public finances are close to being in a mess, partly because of the fiscal stimulus to support demand and partly because of higher spending on vote-grabbing social programmes. Putting public finances back on track will require higher tax collections and more economic output.

It’s a bit of a race between growth and inflation.

Policymakers have to gamble on the hope that economic growth picks up further before inflation becomes a huge problem. The endgame will come on 28 February, when the government will have to announce a credible plan to cut its large fiscal deficit and thus choose a less expansionary policy path.

Our assessment is that RBI will have to start moving earlier. We doubt goods or asset price inflation will spike to a level that requires the central bank to use more blunt instruments such as an increase in the cash reserve ratio. But a small increase in policy rates in the January monetary policy could be a start.

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