The setting for the April 29 credit policy announcement this quarter is very challenging. Last week’s CRR hike should be viewed as a demonstration of RBI’s dilemma: there are no obvious answers to what Governor Reddy should do. Earlier this month, the Raghuram Rajan Committee on financial sector reform released its draft report, in which it said that the RBI should have a single goal. It should focus on inflation. This recommendation has come under criticism from a lot of economists who believe that India can continue to act as if it is financially closed, or almost closed, to global capital flows. The monetary policy challenges faced by the central bank serve to highlight exactly the point that underlies the argument for a single goal made in the Raghuram Rajan report.
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 bank’s 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