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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 CRR would  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 RBI’s 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.