Inflation is undoubtedly the key concern in economic policy today. The inflation situation is worse than it appears, because of various price control measures. Officially, the CPI-IW is nudging 8%. The international press is dominated by the US Fed, the Bank of England and the ECB. When these central banks see higher inflation, they tighten the short-term ?policy rate?. Such tightening does not make much sense in India. The critical piece missing in India is a meaningful monetary policy transmission, through which changes in the policy rate of the central bank propagate to other interest rates in the economy. This lack of a monetary policy transmission is caused by the lack of the bond-currency-derivatives nexus. The systematic policy strategy of the RBI has been to prevent the development of a sophisticated bond-currency-derivatives nexus from developing. As a consequence, RBI has been reduced to ineffectiveness.
The real focus should be not on interest rates but on the currency. And monetary policy blundered in trading on the exchange rate market. From 2005 onwards, RBI furiously bought dollars in order to prevent the rupee from appreciating. This led to a massive injection of liquidity into the economy. With a long time lag, this is inducing inflationary pressures. In early 2008, RBI mysteriously stood by while the rupee depreciated. A rupee depreciation directly fuels inflation by making foreign goods costlier. It is not clear why RBI has built up such large foreign exchange reserves, inflicting costs upon the economy such as capital controls, the interest cost on MSS, and the capital losses suffered when the dollar depreciated, if there was no plan of using reserves to prevent precisely this event. Elections are looming large, and the UPA needs to rapidly find a sensible macroeconomic policy strategy. Three key policy levers need to be put into play in the fight against inflation. First, the capital controls on ECBs that were announced in August 2007 need to be reversed. Second, the capital controls against PNs announced in October 2007 need to be reversed. Third, reserves need to be sold on a massive scale, so as to get a 10% rupee appreciation. This will simultaneously give a 2 to 3 percentage point impact on the WPI, and reduce liquidity in the domestic economy.
