now is the opposite. The rupee has tanked because of investors' misgivings about India's bloated trade deficit. In July, the RBI raised short-term interest rates by 3 percentage points to prevent capital outflows, showing once again that it cared less about the currency's domestic purchasing power than its value in overseas transactions.
Rajan is now dismantling his predecessor's ill-conceived defence of the currency. In this, he has been lucky. The rupee is stable at about 62 to the dollar. But danger lurks. Nobody quite knows how the central bank will respond if expectations that the U.S. Federal Reserve will soon start withdrawing excess dollar liquidity resurface, putting the rupee under renewed selling pressure.
Yet Rajan's goal must be to tone down the importance monetary policy assigns to variables other than inflation. Exporters become complacent because they know that the monetary authority tends to fight currency appreciation. A good example is the Indian software industry. It has been wildly successful because of the country's cheap labour, but has underinvested in research, and is struggling now to develop its own intellectual property. Similarly, knowing that the central bank will cut interest rates to keep output at an even keel absolves the government of its responsibility to boost the capacity of the economy.
India's hotchpotch monetary rule has also failed to anchor inflation expectations. Even with GDP growth at a 10-year low, surveys show people expect prices to keep galloping. If citizens were confident that the central bank would bring inflation down because that's what it always does, then some of that faith would show up as lower inflation today.
Looking at inflation, Breakingviews' analysis of past RBI behaviour suggests overnight rates should be around 8.4 percent. The central bank's determination to shore up the currency would add 0.9 percentage point to the theoretical number, while its desire to reduce the output gap would reduce it by 0.6 percentage points. Combine the three ingredients, and the final rate - based on historical trends - should be 8.7 percent for the third quarter of 2013.
But following Rajan's intervention, the actual rate was 9.5 percent on Sept. 25. Since Rajan's actions suggest he cares less about the value of the rupee and lost output, the higher observed rate points to one explanation: banks believe the new governor is putting a greater emphasis on controlling inflation than before.
This new rule, if Rajan can make it credible, could lead India to