Looking back this year, in January there was an argument for cutting interest rates to reduce interest differentials with the rest of the world. Since July, when the US started cutting rates, capital inflows into India tripled. This was to a large extent in response to the interest differential that had reached nearly 500 basis points. In its attempts to prevent rupee appreciation, the RBI was buying up dollars which it was then trying to sterilise. Monetary policy was being implemented through RBI intervention in currency markets, and the sale of government bonds to sterilise the impact of its intervention. The rupee was pegged to the US dollar and kept flat between Rs 39 to 40, except for a brief period when the RBI tried to engineer a depreciation by purchasing huge amounts of dollars.
The setting for the credit policy announcment is similar, except for one big difference. A sudden and sharp increase in inflation has added a new dimension to the problem. At the same time, US interest rates have continued to decline and the interest differential with India has widened. The US 90-day treasury bill rate is 1.04%. The gap with Indian 91-day bill rates is 600 basis points. Any increase in interest rates in India will widen the spread, attracting more capital inflows into India and pressuring the rupee upwards. If the government and RBI decide not to allow rupee appreciation, the central banks trading will inject more liquidity into markets. In an inflationary environment, that is not desirable. Even if raising rates was expected to be useful in combating inflation caused by global commodity price rise, given that foreign interest rates are much lower, instead of reducing liquidity in the system, it may actually increase it, and may therefore not be the best policy option.
This presents the biggest challenge. Raising rates will make it very difficult for the RBI to continue its currency policy. If it does so, then it will have to struggle with the increase in liquidity. One option the RBI could adopt in such a situation is to raise the CRR, which is what it did last week. A higher CRRwould mop up the additional liquidity that will come into the system when the RBI intervenes in foreign exchange markets. But CRR hikes put pressure on banks to raise interest rates further.
Clearly, there is no easy solution to the problem. The basic difficulty is the inconsistency of the monetary policy framework. If India wants to tighten monetary policy when the US is following a loose monetary policy, then India cannot peg the rupee to the US dollar. If we do so, then we import US monetary policy. The RBIs answer to this has been to undertake sterilised intervention to beat the constraints imposed by the impossible trinity. However, sterilised intervention maintains the high interest differential and money continues to come in, making it more and more costly for the government.
This the current context in which Governor Reddy must operate, and it highlights the difficulty in our monetary policy framework. The question politicians are addresssing is the here-and-now question. Even if over the next few weeks this question is solved and inflation goes down, what needs to be addressed is the larger question of how to achieve a low and stable inflation rate for India. Lurching from one inflation episode to another, and pulling out tools from the days of the Emergency to distort markets, is no way for India to now behave.
What India needs is fresh thinking on macroeconomic stabilisation in an open economy framework. While one may have a debate on whether the target should be inflation or, as some economists believe, exchange rates, it is time that we accept the reality that the framework of monetary policy in India needs to change. It needs to be designed for a financially globalised world where control and licence raj solutions will not work. Indian politicians dislike inflation. They are right. But this sentiment needs to be redirected away from raiding traders or banning futures markets to putting in place a better monetary policy framework.
Ila Patnaik is senior fellow at National Institute of Public Finance & Policy. These are her personal views