Even before the dust has settled from last week’s status quo monetary policy announcement, analysts are already recommending and predicting tightening actions by the Reserve Bank of India (RBI) as early as December. Whether circumstances will change so dramatically for the better over the next couple of months is a legitimate question, the answer to which will determine the appropriate timing of any monetary response. As of now, the nature of the response is being seen by many as a largely predictable one — beginning with an increase in the cash reserve ratio and moving fairly quickly on to increases in the benchmark repo and reverse repo rates. But, it is important to point out that these standard responses to steadily increasing inflationary pressures will have to be done in an already complicated environment. Various factors are at work, pushing the economy in different directions, and a policy response that addresses one of these may well be neutralised by the behaviour of others or even exacerbate a problem somewhere else.
It is worth highlighting a few factors that can potentially disrupt the slow climb back to high growth and macroeconomic stability. First, there is the almost unnoticed increase in oil prices to levels above $80/bbl. This is partly the result of greater optimism about a global recovery, which is fine, but also the consequence of global liquidity in search of returns. A rapid ramp-up in energy costs will unquestionably threaten the US recovery, which, in turn, will dampen global prospects. Further, as the recovery raises overall levels of capacity utilisation, the risk of oil prices causing an inflationary spiral increases. Central banks will feel pressure to respond in ways similar to early 2008, a jolt that might precipitate another recession. Second, from the perspective of India as well as other emerging markets, liquidity in search of returns could lead to an embarrassment of riches in terms of capital inflows. At a time when central banks are working towards moderating demand through tightening of liquidity, this flood can severely restrict their ability to do so. Currency appreciation is always an option, but will come with its own set of disruptive influences. Third, while the overall mix of fiscal, monetary and financial policy responses to the crisis appears to have worked, it is hazardous to venture a guess on which of the components of the overall package worked and which didn’t. This makes the whole exit process, which is now the focus of macroeconomic policy around the world, extremely risky. In this fuzzy state of awareness, there is a good chance that policy-makers will do the wrong thing at the wrong time, bringing down the whole house of cards. In this context, the timing and magnitude of monetary actions need to be acutely sensitive to things that are happening on the fiscal and financial fronts, domestically and globally. The way forward is hardly as smooth and predictable as some analysts make it out to be.