Occurrence of trade cycles has become inevitable with most countries moving towards freer yet more cautiously controlled economic models. It also underscores the importance of prudent economic policy composed of fiscal and monetary measures. Given the inter-connectedness of countries, the responsibility of all central banks has increased manifold, especially post-sub-prime financial crisis. Willy-nilly, people have accepted that financial crises can strongly affect the real economy, also of other countries, for a long period. Since such crises, often both created and cured by central banks, touch everyone?s lives, it?s necessary for post-graduate students, especially of management, to understand certain related aspects. This article discusses the current issues of central bank targeting and autonomy, monetary tightening and the inflation-led policy rate hikes.

Central banks have certain ?targets?, namely inflation, GDP growth rate, interest rates, money supply, exchange rates, etc. But there is a trade-off between these targets, for instance, attempt to lower inflation by reducing money supply adversely impacts growth rate and unemployment. Hence, the central banks need to prioritise the targets depending on the needs of the economy at the time. RBI is equipped with monetary policy instruments of the bank rate, repo and reverse repo rates, CRR, SLR, margin requirement, selective credit control, etc. Each of these tools has its own way of working out, its own effectiveness, flip-sides and ?time-lags?. Again, the economy?s need determines the operative tool, which RBI selects in its own power.

Some hold that since the monetary policy needs to accommodate and move in tandem with the fiscal policy, given the nexus between the two, the concerned ministry should rule supreme over the central bank. But a democratic government is often tempted to undertake measures that reduce government?s revenue while raising its expenditures, which works to the detriment of the economy and good politics can prove bad economics. A powerful central bank provides a counter-check on such populist government measures. It also provides a scapegoat to the ministries when they face a catch-22 situation. Yet central bank autonomy remains quite a myth even in the most advanced nations, though developed countries are now trying to give more teeth to their central banks. Recently the Indian intelligentsia, too, has knocked down the finance minister?s attempt at diluting RBI?s autonomy and dignity by strongly opposing the proposed FSDC with the FM at its head.

At present, RBI?s top priority is inflation, which has been hovering near double-digits, while growth rate is not an immediate worry. RBI has raised repo and reverse repo rates five times this year, the latter more sharply, thus narrowing the LAF corridor. Repo and reverse repo rates are RBI?s lending and borrowing rates. When RBI buys T-bills from banks at a certain price with a simultaneous agreement to sell them later at a higher price, the difference between the two prices is a form of interest, known as ?repo? rate, reverse-repo being the opposite. RBI infuses money into the economy through the former and mops up through the latter, both windows being open simultaneously. It?s interesting to note that earlier we had monetary policy twice a year?busy season and slack season. Later quarterly credit policy started, and now we have mid-quarterly policy, indicating the volatility and speed of changes requiring frequent RBI intervention.

Another issue being discussed is, with inflation plateauing out, RBI must now take it easy, wait and watch. Since monetary policy works with a time-lag, by the time the five successive rate hikes show full impact, inflation would have tamed due to good monsoon, end of busy season, greater supply of goods, besides monetary tightening. Another rate hike is unwarranted and might throw wet blanket on both investment and consumption demand, while some other economies move into a double-dip, reducing our export demand. The negative real interest rate (nominal rate minus inflation) is probably another cause of rate hike. But when inflation comes down, and nominal rates cannot, the real interest rates will automatically move into positive territory, attracting capital inflows due to ?carry trade?. Also, Bank of Japan?s intervention to keep Yen from appreciating will discourage currency speculators who will divert some funds to India. All this dollar inflow could appreciate rupee and worsen India?s current account deficit. If RBI buys the stream, the infused rupee supply will raise inflation. If RBI sterilises its intervention by selling government bonds to mop up excess liquidity, the government becomes more indebted. This is the impossible trinity Subbarao talked about at Hyderabad University. So, capping capital inflow might be an option.

Unfortunately, there are more such challenges before RBI. Besides inflation-growth trade-off, financial stability in face of bubbles followed by crises is another challenge. As Alan Greenspan said, let bubbles build, burst, and then let?s clean up the mess. This is one way of looking at it. The other extreme is the G-20 nations? recent plea to the Basel committee to formulate a more stringent Basel-III to prevent future crises. A golden mean would be, to put in place an early detector and in-built automatic stabiliser, which smells and fights the potential crisis as soon as it?s signalled and nips it in the bud. For this, not just the government agencies but also business leaders and executives must join hands with RBI in the war against crises. Evidently, it?s necessary to give an analytical understanding of the challenges of monetary policy to post-graduate students, especially of management stream.

The author is visiting faculty at IIPM, Symbiosis Institute of Management Studies, Pune, and Disha Institute of Management and Technology, Raipur