RBI?S quarterly economic review released yesterday had, as is proper, quite a lot to say about inflation prospects. To quote in extenso: ?The inflationary pressures may remain moderate if the protracted global recession leads to dampened commodity prices, agricultural growth remains unaffected despite delayed progress of monsoon and the accommodative monetary policy stance returns to normal levels.?Note that domestic farm output variability is a supply-side factor that may push up food prices, but doesn?t automatically call for hardening monetary policy. Note also that if global commodity prices do go up in the near future because global recovery is quicker, this will be a price pusher that?s indifferent to domestic monetary tightening. Indeed, that?s precisely what happened when the pre-financial crash commodity price boom fed into India and it wasn?t tight monetary policy that killed that inflationary spurt, but falling commodity prices. Taken together, these two factors should ideally tell RBI that if and when inflation is deemed a problem, the efficacy of a monetary blunt instrument should be looked at closely. Evidence of teh last two years shows reasonably clearly that monetary policy hardening in the face of supply-side or global commodity price cycle-related factors have more impact on investment and less on price formation expectations?because these expectations are formed in contexts that don?t necessarily respond to high interest rates.
However, note that RBI says if monetary accommodation returns to ?normal? levels, inflation will be moderate. Should this be taken to mean that the central bank continues to believe in monetary tightening irrespective of the nature of inflation? We will find out. We will also find out how RBI responds to higher capital inflows this time. India?s getting FII attention again. China?s getting much more and already has had to sterilise dollar inflows. Will RBI again massively intervene in the capital flows context to manage the exchange rate (exports, remember, are weak) or will its approach be softer this time? This will have a bearing on the monetary policy stance since the greater the intervention here, the more the impact on liquidity. This is not a big issue right now, but if global money continues to find China and India as the two stories that are worth betting on, the whole inflows-intervention-exchange rate-inflation issue will come up big time. When it comes up is crucial, too. Because private investment, the most crucial growth determinant, needs this fiscal to have an easy monetary regime. RBI noted in its quarterly review that credit growth is moderating. Any monetary policy hardening in the near future can have a substantial impact on investment and growth.