The Reserve Bank is to make the next credit policy announcement this week, and it has little option but to tighten monetary policy. Inflation has been high and rising, and the government appears to have finally given up hope that it would somehow come down without a significant intervention. While this phase of inflation has been largely caused by higher food prices, it will be a while before agricultural or organised retail reforms can be implemented and ease supply constraints. Faced with public discontent, the government tried the usual recipes of acting against traders and hoarders — to, as expected, little effect.
In this context, traditional approaches such as fiscal and monetary contraction need to be adopted. These would serve to reduce demand, while supply conditions can be addressed by longer-range steps. Reduction of demand and containment of inflationary expectations through monetary contraction may reduce some borrowing and investment in the short run. However, given India's high growth, this is a good time to take tough measures before other elements of the economy, such as infrastructure, also start facing supply constraints. Lower, stable inflation has no long-term conflict with growth. Indeed, it is conducive to investment. Few companies would be willing to invest long-term if they do not know how much their costs will rise and whether a project will be profitable or not.
The RBI should show clearly, in its credit policy announcement, that it will not tolerate high inflation. It should hike rates by 50 basis points at least, to indicate that it is now comfortable with affecting short-term investment sentiment in favour of pursuing a policy of low inflation. Even without inflation being its only objective, it must indicate that inflation is indeed one of its important objectives. It cannot talk about ensuring financial stability if it cannot deliver low inflation. While the Centre should later chip in through fiscal consolidation, the monetary authority cannot escape its responsibility. All over the world inflation is treated as the responsibility of the central bank. In India too, the RBI needs to take the lead, and do what it can to put inflation control at the top of the policymaker's agenda.
