Transmission impossible

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: objective. We have not seen RBI do any such thing. On the contrary, it has been claiming that all is well and under control.

The recent bout of inflation has been blamed purely on global factors. Here too, if RBI had not been buying dollars, rupee appreciation would have ensued. This would have made foreign goods cheaper. Imported goods such as food, fuel or metals would have been cheaper because the exchange rate would have been more favourable. This would’ve meant lower inflation for tradeables.

Put together, through these two channels, a central bank that cared about inflation would have behaved very differently from RBI in the last few years. All countries in the world are exposed to this difficult global environment with high commodity prices. But we have done worse than countries with a proper monetary policy framework designed to contain inflation.

The third area where RBI reforms would yield a fundamental change in behaviour lies in financial sector reforms. At present, RBI uses its institutional might in preventing the development of currency and bond markets. Sophistication in these markets is feared by RBI because it will lead to a loss of control over foreign exchange and interest rates. This is not how monetary policy is best implemented.

A central feature of monetary policy functioning is the policy’s “transmission". The central bank makes small changes to the policy rate, and this affects interest rates across the entire economy through the functioning of the bond and currency markets. A sophisticated “bond-currency-derivatives nexus” is the essential tool through which a central bank achieves influence over inflation.

When inflationary pressures arise, the central bank changes the policy rate by a small amount, and the bond-currency-derivatives nexus does the rest of the work by influencing interest rates all across the economy. If RBI had cared about inflation, it would have supported the reforms required to build this nexus. Instead, what we saw was an RBI that cared about pegging the exchange rate, and used its power to ensure that India does not have a good bond or currency market.