Deepak Mohanty, executive director, Reserve Bank of India (RBI), said that the recent surge in inflation has raised concern on whether the supply-driven increase could spill over to the generalised inflation process.
?Prolonged high inflation even if originating from supply side would give rise to increase inflation expectations and cause general prices to rise. Poorly anchored in inflation expectations makes long-term financial planning more complex with potential adverse effects on investment and growth,? said Mohanty.
Accordingly, the RBI has begun its exit from expansionary monetary policy in October 2009 by reducing the potential liquidity.
Mohanty was delivering a speech on the implementation of monetary policy and inflation dynamics in India at the Bankers Club in Bhubaneswar on March 15. He strongly noted that it is therefore important to keep inflation expectations anchored so that consumers do not mark up their long-run inflation expectations by reacting to a short period of higher-than-expected inflation.
?Higher the inflation rate, the longer it takes for the inflation to reverse its trend. Slow return of inflation rate to its equilibrium level after a supply shock is known as ?inflation persistence?, which is important in the determination of the pace of monetary policy adjustment to achieve the desired target,? said Mohanty.
In the Indian context, empirical analysis shows a high degree of persistence, especially in the case of food and edible oil groups. This hinders supply responses to work in a timely fashion, he added.
Even though supply side factors dominate the current inflationary pressures, given the risks of spillover into a wider inflationary process, there is a need for policy response, advocated Mohanty.
?With the changing framework of monetary policy in India from monetary targeting to an augmented multiple indictors approach, the operating targets and processes have also undergone a change,? said Mohanty.
There has been a shift from quantitative intermediate targets to interest rates, as the development of financial markets enabled transmission of policy signals through the interest rate channel. At the same time, availability of multiple instruments such as CRR, have provided necessary flexibility to monetary operations, he added.
He said, while monetary policy formulation is a technical process, it has become more consultative and participative with the involvement of market participants, academics and experts. The internal process has also been re-engineered with more technical analysis and market orientation. In order to enhance transparency in communication, the focus has been on dissemination of information and analysis to the public through the Governor?s monetary policy statements and also through regular sharing of policy research and macroeconomic and financial information, the RBI executive director said.