The rise in consumer price inflation and decline in industrial production are going to be pressing concerns for monetary policy. Next week, when RBI governor Raghuram Rajan makes the announcement, he will not only have to worry about the impact of a possible US taper announcement a day later, but also that of worsening economic data in India. Recent signs of a recovery have been weak. Hopefully, the contraction in demand will pull overall inflation down, albeit slowly.
When inflation goes up and pushes up inflationary expectations, if the central bank keeps the nominal policy interest rate the same, it means that real interest rates will be lower. The forecast of inflation a few quarters ahead, which is usually what monetary policy targets, will be higher. This logic of standard monetary policy could suggest that the RBI should raise rates. But it is not so straightforward. Since the RBI uses a measure of core inflation, which excludes volatile elements, its inflation forecast will depend on what has happened to core inflation. This is not known yet. The RBI does not release the composition of its core inflation so it is not clear yet whether its forecast is higher and thus, whether or not it will choose to raise rates. By not releasing this data publicly, the RBI has increased the uncertainty about monetary policy actions. Since the essence of modern, inflation-targeting monetary policy is to manage expectations, this is the first step that needs to be taken to increase the effectiveness of monetary policy. Transparency, pre-commitment and consistency are crucial for monetary policy to work. The second step is to announce a CPI target. Since Rajan has indicated that it is consumer price inflation that matters, his credibility will be hurt if the CPI continues to rise but the RBI does not have a stance on how much it should be.
The increase in inflation mainly draws from food prices, which are driven by a 61 per cent increase in vegetable prices. Prices of vegetables, and of onions and tomatoes in particular, have risen rapidly due to untimely rainfall and a