Tactics, not theory

The reason most commonly cited for the sharp tumble taken by share prices is the prospect of an interest rate increase in the US. This could slow down the inflow of FII money into India if money starts to return to the US.

Indeed, the Reserve Bank governor has spoken out on this issue on Wednesday, in terms of risk management.

There is no immediate threat of sudden pressure on the balance of payments because most emerging market economies, India included, have accumulated very large reserves since 2002.

Nevertheless, it is useful to understand how the RBI views the problem and in what manner it will tackle it. Its Annual Report on Currency and Finance, published towards the end of last month, contains some clues.

In what must be one of the best-written reports in recent years, it says that "...monetary policy cannot alter the movement of capital flows; it can only hope to fashion a credible response to its effects.

The central banks must inoculate themselves against whimsy and keep their eyes on the fundamentals." It then goes on to say that, thanks to globalisation, monetary policy has to operate in an environment of much greater uncertainty.

And then it comes to the most likely operating procedure. "The monetary policy response should be based on 'bounded discretion' with no activism, smoothness, judgement, flexibility, transparency and accountability."

The key point, it suggests, is to bear in mind that there cannot be a one-size-fits-all formulation of responses, which have to be country specific.

Nor can there be targets, especially for exchange rates. What is needed, instead, is a combination of interest rate and exchange rate policies.

This comes after a chapter on inflation, in which the Report says it does not make much sense any longer to have explicit inflation targets. Far better, it argues, to tackle inflationary expectations.

But having said that, it ducks the issue of monetary policy responses by saying that the bulk of the onus for dampening these expectations lies in fiscal rectitude.

If the government goes on a spending spree, don't ask the RBI to fish the chestnuts out of the fire because, when both international and national liquidity are high, there is only so much that higher interest rates can achieve by way of dampening inflationary expectations.

In short, for those who are wondering what the institutional response to the emerging international trends is going to be, the answer is clear: the RBI will do whatever it takes to keep inflation down and financial stability intact.

Thus, it is not formulae or theory but judgement that will play a key role in policy formulation.

But that leaves open the question of whether the RBI governor speaking out on the need to control fund inflows, in a week when the stock market has been tanking, is the kind of response that one should expect from those in charge of the economy.