A positive fallout from the trans-Atlantic financial crisis is that central banks across the world have become more transparent. Gone are the days of deliberate obfuscation and arcane mumbo-jumbo championed by the former chairman of the US Fed, Alan Greenspan, that passed off as centralbankspeak. Monetary authorities are doing their bit of plain-speaking these days, and the Reserve Bank of India’s (RBI’s) annual report released this Tuesday is yet another example of this. The macroeconomic assessment in the report, somewhat predictably, identifies inflation management as the key policy challenge and reiterates its commitment to this objective. However, it also mentions a set of riders that is likely to influence policy action. For one, it clearly states that the exact source of inflation is important in determining the efficacy of monetary policy — inflationary pressures predominantly driven by supply shocks are less amenable to monetary intervention. Second, monetary policy has to take into account changes in global outlook and manage potential global shocks. Third, the government’s hefty borrowing programme has to be managed effectively (presumably by keeping a check on sovereign bond yields) in an environment of high inflation and a possible increase in private sector credit demand. In short, RBI seems to be keen on breaking the linear, mechanical link between inflation and policy interest rates that prevailed in the earlier, pre-crisis regime.
Thus, while inflation remains priority number one, RBI makes no bones about the fact that it will have to juggle multiple objectives along with inflation control. Besides, instead of being guided solely by headline price indices, it is likely to look more closely at the “micro-structure” of inflation in taking its policy calls. Some would view this as an attempt by RBI to pussyfoot around the fact that it has failed to rise to the challenge of inflation. Others would see this as refreshing candour from a central bank that has accepted the imperatives of operating in a post-crisis economy. Whatever one’s take is, this is likely to be the central bank’s stance going forward and commentators who tend to be disappointed each time a high inflation print is not immediately followed by a hike in policy rates, should do well to read this section of the report carefully. The report also does its share of plain-speaking on its strategy of managing capital flows. While it recognises that the extreme volatility in global financial markets could periodically result in a surfeit of capital inflows, it appears to reject extreme measures like capital controls to manage the country’s external balances. Instead, it advocates “a judicious mix of flexible exchange rate, sterilisation of the impact of inflows on domestic liquidity, cautious approach to liberalisation of the capital account, and the cushion of foreign exchange reserves” to manage the ebb and flow of external capital.
Finally, RBI minces no words in warning that its degrees of freedom are limited by the fiscal space it operates in. Fiscal imbalance, it points out, impinges both on growth and abets inflation. The RBI report, incidentally, comes a few weeks after the government tabled the first supplementary demand for grants in Parliament which effectively gobbled up a large portion of the Rs 71,000 crore windfall that the government got from the telecom auctions. Unless the Union finance ministry shows more commitment to addressing the problem of a bloated fisc, it is perhaps unfair to expect RBI to work miracles.
