The impact of tighter fiscal and monetary policy on inflation is now visible in the recent price data. Inflation, measured both by the wholesale price index and by the consumer price index, has come down. It may still be too early to cut rates, but RBI Governor Raghuram Rajan can now afford to hold rates unchanged in today’s monetary policy announcement. His strategy of an aggressive attack on inflation, despite the scepticism often voiced in the Indian monetary policy debate about the effectiveness of monetary policy, was the right strategy and is yielding results.
Considering that inflationary expectations in India are high and persistent, and could take a while to come down, Rajan should not cut the repo rate as yet. If the WPI inflation measure is the target, there is a case for cutting rates since this has come down sharply. However, the CPI, the target towards which the RBI sensibly appears to be moving, is still above 8% and there is fear that it may go up due to unseasonal rains. Also, CPI based inflation has not remained low long enough for inflationary expectations to fall.
The fiscal and monetary contraction of the last 9 months, as well as the slowdown in the economy, have contributed to the reduction in inflation. In this environment, effective communication by RBI that its focus will be on inflation control, has played an important role. In addition, the setting up of the Urjit Patel committee and its view that RBI should adopt inflation targeting has helped counter some of the traditional RBI view that monetary policy has no impact on inflation, that India has a weak monetary policy transmission mechanism so there is no point in trying to raise rates, that inflation in India cannot be measured properly and so on.
The war on inflation is still not won. The present dip in inflation must be sustained for many months before RBI can relax. Despite the fall in GDP growth, the consequent slowdown in demand, and the fall in commodity prices, Indian inflation is higher than what is seen elsewhere in the world. Inflation in food has contributed most, but inflation in non-food has also been sticky.
Looking forward, there is a contradiction between RBI’s aggressive stance on inflation and its intervention in the foreign exchange market. RBI’s stance on monetary policy could be undermined by its intervention in the foreign exchange market. In