Last week’s policy statement of the Reserve Bank of India (RBI) signifies a departure from the stance it has been adopting in the last three quarters.

There are three elements that are different. First, in leaving key policy rates unchanged it has acknowledged that liquidity is not an obstacle to growth at present, but banks are reluctant to lend. Second, by acknowledging that the growth of money supply at 20% is high and needs to be brought down (“a projection, not a target, of 18%", as governor D. Subbarao said in the press interview), RBI has shown that it is concerned about money growth. Third, in cautioning about inflationary pressures, it is setting its sights on a tightening of monetary policy in the near term. All these have significant indications for the economy.

The estimates for growth have been increased to 6.5%, and despite the shortfall in the monsoon, RBI expects that growth will pick up. The first quarter results of most of the manufacturing companies have been good, and many companies have registered a healthy growth over the previous quarter. This is due, in part, to the fact that input costs have come down as commodity prices internationally are ruling at levels far below the peaks of 2007. At the same time, RBI is not able to pitch for a growth rate that is higher, for it considers India a supply-constrained economy and does not see adequate growth in investment portfolios that will ease these constraints.

The consequence of these numbers is that if growth is 6.5-7%, and money supply growth is close to 20%, RBI appears to be getting worried about inflation. While RBI’s rhetoric can be interpreted in many ways, its higher inflation, output and money growth forecast can be argued to represent a relatively clearer and more objective signal of its concerns over inflationary pressures ahead. RBI’s inflation forecast implies a sequential rate of rise in prices of around 5% from July 2009 to March 2010. In other words, inflation would already be higher than the “range of 4.0-4.5%" that RBI wants to “condition perceptions" to. The statement reflects a shift in RBI’s stance from supporting growth to watching inflation closely.

RBI’s task of simultaneously managing inflation and the government’s borrowing programme may become a major challenge in the months ahead. In India’s case, RBI’s dual mandate to support growth and control inflation, and the lack of clarity on whether output is running above or below potential at any point, has meant that RBI tends to move rates only after it sees inflation rising. This is what happened in 2008, and will probably be what happens later in 2009 or early 2010.

There is another factor that is likely to exacerbate inflationary pressures. Additional allocations for the National Rural Employment Guarantee Scheme (NREGS) this year are substantially higher than last year. Several good monitoring systems have been put in place that ensure leakages are getting reduced. There is secondary evidence that the money is reaching those who need it; though there is an outcry in the media that the programme is artificially increasing wage rates and thus putting pressure on manufacturing costs. More importantly, as a columnist in the Business Line pointed out recently, more money in the hands of the poor means that where they had been having one meal a day, they are able to have two or at least a meal and a half.

However, NREGS does not focus on agriculture or food production and, hence, there is little or no impact of the scheme on agricultural output. This has had an effect on food prices. While there are adequate stocks of rice and wheat in the public distribution system as well as in the open market, there is pressure on other food articles—most importantly, on pulses (these are an important ingredient in the Indian food basket), meat, sugar and vegetables. The Consumer Price Index increases hover around 10% on a year-on-year basis, and there is likely to be greater pressure on the food articles component of this index. The poor monsoon is also likely to exacerbate this impact. The next few months will see a sharp increase in the prices of food articles. Coupled with the inflationary pressures already mentioned, it is likely that there may be a fresh bout of high inflation, forcing the government to rein in monetary expansion. This is likely to constrain expectation of growth in the coming year.

Finally, the buoyancy in the financial markets appears to be due to the good first quarter results companies have just published, coupled with the considerable liquidity available in the economy. The Asian stock markets have recovered to some extent, and there is a flow of foreign funds into the Indian markets. It is unlikely that this buoyancy will be sustained if there is a threat of high inflation and monetary contraction leading to a contraction in growth. In short, the increases in the equity markets are unlikely to be sustained.

The country will be going through some pains in the next few months, a fact that RBI has already discovered. We can only hope that these pains are not exacerbated by increases in commodity prices as well.

S. Narayan is a former finance secretary and economic adviser to the prime minister. We welcome your comments at