YV Reddy got a lot of praise when he did not raise rates in credit policy 2006-07. Ironically, the credit policy statement is full of indications that the Reserve Bank of India (RBI) perceives inflationary expectations to be high. This view on future inflation appears inconsistent with the decision to keep rates unchanged. Saying that RBI will keep a watch on inflation and act when the need arises will confuse the public and is not the best way to manage expectations and conduct monetary policy.

Most of us do not run models to forecast inflation. But we believe central banks do. If inflationary expectations were actually low before the credit policy announcement, there are few who would not have revised their opinion after reading the policy statement. RBI has made a convincing case for expecting higher inflation. The impact of higher world oil prices has not seen a complete pass-through to domestic prices in India, but it has to happen. There may not be clarity on when the inflation rate will go up, but after reading the statement, one comes away with the distinct feeling that inflation rates are on their way up.

Life is not easy for central bankers. Based on a variable that is not observed ?inflationary expectations?they have to use instruments like interest rates that are known to impact inflation after about at least a year-and-a-half. RBI has to choose from a number of instruments available to it?the cash reserve ratio, the bank rate, the repo rate.

Moreover, it has to use flawed measures of inflation rates, whether based on WPI or CPI, whose data is collected by other agencies and which do not offer a clear picture for decision-making. The government of India has further burdened RBI by imposing upon it the tasks of public debt management, currency management and banking regulation, which often have conflicts with the conduct of monetary policy.

However, despite the difficulties, in recent times central bankers have been increasingly successful in the conduct of monetary policy by managing expectations. For example, when Alan Greenspan felt that inflation in the US was rising and interest rates should go up, he made many speeches saying so and then followed these up by raising rates. The Bank of England has managed expectations by setting up a transparent mechanism?the Monetary Policy Committee?which is given an inflation target and which puts up the minutes of its meetings on its website. This allows people to know why certain decisions are being taken and to know what to expect.

? Credit policy indicates that RBI perceives high inflationary expectations
? Saying that RBI will watch inflation is not a good way to manage expectations
? RBI should decide on rates, announce this and then raise these in July

Why is it important to manage expectations? Primarily because the effectiveness of monetary policy depends on what the private sector expects from it. The research on rules vs discretion, credibility and time-consistent policies, inflation targeting and Taylor rule all agree on one thing. That the private sector factors in what it believes is the central bank?s policy and that makes all the difference to the impact of these policies. When households and firms make decisions, the outcomes are much better when interest rates move as expected.

The credibility of the central bank is of utmost importance. Private agents form expectations and make decisions based on what rules, explicit or implicit, they expect the central bank to follow.

Credit policy 2006-07 leaves Dr Reddy with a difficult task. His policy document makes it very clear that inflationary expectations are high. Yet, he did not hike rates. As a consequence, people can no longer expect that if RBI perceives inflation to go up, it will hike rates. Listening to RBI for the last few months had created expectations that rates would go up. Even one hour before the policy, there was confusion?half the analysts on TV were saying rates would go up, the other half were hoping these would not.

What should be done now? The internal decision to raise or not raise rates in July (or before that) should not be left until then. Within RBI, it should be made now. Then, if he is going to raise rates, Dr Reddy should say so, and keep saying so again and again, till people are sure that he will. And then come July, he should raise these.