Entirely expected

The increase in the cash reserve ratio (CRR) by the Reserve Bank of India (RBI) on Tuesday was an entirely expected move, though the timing may have been a surprise. Coming as it did only two weeks after the RBI had raised the repo rate, it is entirely legitimate to ask the question: Did they not anticipate the need to constrain liquidity to make the interest rate hike bite? Particularly, given the circumstances that led to the CRR hike on December 8, the consideration that large capital inflow was offsetting the restrictive impact of interest rate hikes by providing the banks with an alternative channel of liquidity should perhaps have influenced the announcement on January 31. Be that as it may, the RBI is clearly living up to the Governor's commitments to use any and all means available to resist the inflationary spiral. Will it work?

Yes and no. Yes, to the extent that a persistent monetary stance against inflation is critical in influencing expectations about the course of price increases. It is well-known that monetary policy works with a lag of anywhere between 12 and 24 months; no one should expect an immediate dip in the inflation rate as a result of an interest rate hike or a CRR increase. One could argue that, since the RBI has been in inflation-fighting mode since October 2004, some impact should have been felt by now. There are two responses to this. One, it is quite likely that the growth and inflation rates would have been even higher than they are today in the absence of a restrictive monetary policy over the last couple of years. Two, the very factor that has persuaded the RBI to resume the use of the CRR after two years of exclusive use of the repo and reverse repo rates, viz. capital inflow, may well have diluted the impact of interest rate hikes over this period. Absorbing excess liquidity through devices such as the market stabilisation scheme, which the RBI introduced in 2004 as a way of sterilising its forex reserves build-up, is inherently limited by the banks' willingness to buy the securities that the RBI is selling. If banks find the returns on lending activity more attractive, they will shun RBI offerings. This is exactly the situation that the economy is in now. There really seems to be no alternative available to coerced limits on liquidity.

But, it should also be kept in mind that food prices are a large contributor to the recent inflationary spurt. Monetary policy will not have a significant impact on these; they are the result of constraints in the supply of several food items. Some of these are temporary in nature and things will get back to normal with the next crop. Others, particularly with respect to critical items like wheat, are structural and there is no immediate or easy solution available to the RBI, or anybody else for that matter. Perhaps this crisis will induce much-awaited changes in the agricultural sector, but in any event, the payoffs to that will be some time in coming. In the meantime, we should accept the limitations that the RBI faces in dealing with the current inflationary situation and the logic of what it is doing, if not the rather disruptive sense of timing.