Keep the focus

The Reserve Bank of India has hiked interest rates,narrowed the LAF (liquid adjustment facility) corridor,and announced mid-quarter reviews of monetary policy. Anticipating high inflation and growth,the credit policy statement of RBI Governor D. Subbarao had a clear hawkish tone. It indicated that in an environment of high inflation and rising inflationary expectations the RBI will keep liquidity tight. The move to announce mid-quarter statements will help take the surprise of frequent rate hikes away from the market.

The focus on inflation and monetary tightening was expected in the present scenario. India is among the only countries witnessing persistent inflation. The governor’s monetary policy statement laid the path for a series of small hikes in interest rates over the next few months. It is clear that the commitment to control inflation is going to be the RBI’s prime concern. While in the short term there could be a trade-off between growth and inflation,in the longer run a low and stable inflation rate provides businesses with a healthy investment environment and is essential for high growth. Businesses can make plans with greater confidence,consumers get encouraged to save when inflation is low,rather than when value of their saving is falling. The political environment in India favours low inflation as it is a highly emotive issue. This helps the central bank in pursuing its objective of low inflation.

The RBI’s next job should be to explicitly extricate itself from functions where there is a conflict with inflation control. While inflation-targeting as the sole objective of a central bank has become less popular after the crisis and the slogan today is inflation control with financial stability,in India the first step is to pull out of functions like debt management of the government and currency manipulation. While the RBI has stayed away from forex markets for a few months now,the next step is to institutionalise this arrangement and define the role and function of the RBI,putting an explicit focus on inflation. For example,the development of financial markets has been hampered by the RBI’s role in currency manipulation,as it stepped in to prevent the development of bond currency derivative markets which would increase capital flows to the country. This,however,prevented a healthy transmission mechanism of monetary policy. In the RBI’s statement there is an argument that tighter liquidity allows the transmission to happen. While this may be an interim solution,the RBI now needs to focus on development of financial markets to improve the transmission mechanism.