Virtues of inaction

There is a view that effective central banking in this era of deep global economic integration works on two tenets. First, of all the variables that a central bank can aspire to influence, domestic inflation is the one most amenable.

Second, never do anything today that you can put off until tomorrow. Over the last few years, the Reserve Bank of India (RBI) has displayed its proclivity to these two principles, barring a couple of exceptions, like last April. Its quarterly review, released yesterday, indicates a welcome return to the "do-nothing" position that is by far the most appropriate under the circumstances.

From a macro-economic perspective, the Indian economy continues to display top form. GDP growth at around 7 per cent for three successive years (most forecasters are at or above this benchmark for 2005-06) accompanied by inflation below 5 per cent, at a time when crude oil prices are at their highest in over a decade, is nirvana by the standards of emerging markets, not to mention the developed economies.

Forex and food reserves provide impenetrable buffers against virtually any external or domestic shock; the former allows the country to finance a large trade deficit, so shortages of virtually anything that can be imported are firmly in the past. Interest rates have moved to a highly stimulatory level as a consequence of financial reforms.

The one sore spot, the fiscal deficit, is showing signs of coming under control. In the short term, at least, there are really no demons on the horizon.

Not that there aren't any potential spoilers in sight. The RBI review takes great care in listing out several factors, which can disrupt an otherwise smooth ride. Among domestic concerns, tightening capacity is a critical one. It doesn't matter so much in the manufacturing sector, for example, because there are few constraints on imports. In fact, the relatively subdued inflation rate for most manufactured products, despite rising commodity and energy prices, indicates just how powerful a force openness is in curbing inflation.

The problem lies essentially in the non-tradable sectors""infrastructure, in particular, in which capacity constraints are a perennial threat to the sustainability of growth.

On the external front, oil prices remain by far the most significant threat. They have been so for over a year now and some complacency may have set in amongst policymakers around the world about just how far they can go.

The RBI admits that the threat has remained in the "potential" category so far but rightly warns that the future course is unpredictable and current decisions must take into account the possibility of steep increases in the future. But that is an eventuality that must be dealt with when it arises; there is no point in anticipating it, particularly with monetary instruments that are largely ineffective against cost-push inflation.

One incident induced expectations amongst some people of an activist stance on the part of the RBI. The finance minister said last week that he was worried about the runaway increases in stock prices.

Although this concern was later qualified with a Sensex value of 8,000, it could well have been a signal to the RBI to dampen enthusiasm with an interest rate increase. However, the RBI has revealed that it has a mind of its own and also provided an assurance that it is taking the two tenets to heart.