The Bible’s Book of Isaiah warns that there is no rest for the wicked. The same could be said of the Reserve Bank of India (RBI) and of central bankers in general. RBI’s tireless efforts to put the economy back on track seem to be paying off but it can hardly afford to take a break. Inflation has been climbing up steadily and wholesale price inflation for March is likely to print in double digits. What is more worrying is the fact that inflation is no longer confined to food. Core or non-food inflation has moved up sharply in the first quarter of 2010 and is likely to climb higher as more companies respond to improving demand for their products by hiking prices. In December 2009, core inflation was 0.5 per cent; by February 2010, it had moved up to 4.5 per cent. High commodity prices that currently prevail in global markets aren’t helping either. Unfortunately, the central banker’s book has a limited set of tricks. In a situation of rising inflation and robust growth, the only option for RBI is to hike policy rates and tighten liquidity to rein in inflation expectations. A hike in reverse repo and repo rates of a quarter of a percentage point each and a half percentage point increase in the cash reserve ratio would suck out roughly Rs 23,000 crore from the system.
Why not a sharper increase? There are a couple of arguments against excess tightening at this stage. The first is that the recovery, particularly in investments, is still nascent and a sharp escalation in interest rates could take away the punchbowl before the party has begun. Besides, there are hefty borrowings by the central bank (Rs 287,000 crore in the first half itself) and it is best to be cautious at this stage when it comes to interest rate policy. Second, one could argue that the central bank needs to really press hard on the monetary brakes only when the credit market shows signs of overheating. While credit growth has certainly picked up over the last quarter (the current year-on-year growth rate is about 16 per cent compared to 12 per cent in December), it is still fairly sedate. Third, a sharp increase in rates breeds the prospect of inducing large capital inflows chasing yield arbitrage and could pressure up the rupee further. Given the sharp appreciation in the rupee and the fears of eroding currency competitiveness (the real effective exchange rate of the rupee has gained a whopping 4 percentage points since December), RBI should enunciate its long-term strategy for the currency in the policy. This newspaper believes that for the economy to get back on a higher growth trajectory, a competitive exchange rate is critical and the central bank must affirm its dharma in the management of the rupee.
Finally, RBI might want to use this occasion to assert its role as the key financial regulator. This is important given New Delhi’s plans to create the financial stability and development council that is likely to be a super-regulator in the financial sector. This newspaper has argued that instead of creating yet another regulatory entity, RBI should be entrusted with this task. But to take on this mantle, RBI will have to play elder statesman. The odious controversy over Ulips could perhaps have been avoided if RBI had pulled its weight in the High Level Coordination Committee of regulators and prevented the public spat between the insurance and stock market regulators. The time has come for the central bank to stand up and be counted.
