Price of wrong price strategy

Times of India, June 2, 2022

India is now facing a dual problem of low growth and high inflation. The recovery has proved much weaker than expected, with growth amounting to a meagre 4.1 percent in the fourth quarter of 2021-22. At the same time, inflation has been surging so much so that over the past few weeks the government has taken a wide range of measures to deal with it. Unfortunately, this strategy is misplaced. The government’s actions will have only a marginal effect on inflation, while they may do significant damage to the incipient recovery. The government needs to step back from the inflation fight, and instead encourage the RBI to tighten monetary policy.

CPI (consumer price index) inflation was close to 8 percent in April, nearly double the RBI's legally mandated target of 4 percent. Most of this inflation is caused by supply-side bottlenecks, triggered first by the pandemic and subsequently by the Russia-Ukraine war and lockdowns in China. Yet even as supply has been constrained, the RBI has been pursuing an easy monetary policy, aimed at encouraging demand. As a result, inflation has been increasing.

With inflation surging, and the RBI still in "accommodative" mode, the central government has now announced a slew of measures to ease the supply constraints, focusing on those commodities whose prices have increased sharply. It has banned wheat exports, lowered the excise tax to Rs 8 per litre on petrol and Rs 6 per litre on diesel, and reduced the import duty on steel.

That's not all. The government has also imposed an export duty on steel products at the rate of 15 percent and increased the export duty on iron ore from 30 percent to 50 percent. It has imposed a cap on sugar exports. There is a demand to ban cotton exports as well.

It is clear that the government is trying hard to bring down the cost of commodities. But these actions will only have a modest effect on inflation. Part of the reason is that price increases are no longer confined to just a few commodities. Inflation is now broad-based, extending to virtually every good and service in the economy. Further inflationary pressure is building up, as seen from a WPI (wholesale price index) inflation of 15 percent, the highest in more than two decades. As these wholesale price increases are passed through to the retail level, CPI inflation could rise further.

While the government’s bans and market interventions will do little to dent inflation, they are likely to damage growth by undermining exports and investment. Let’s consider these one by one.

India now faces a historic opportunity to use exports as a lever to boost GDP growth. China, the main export engine of the world, has been locking down its factories even as international firms are scouting for new production locations. Meanwhile, Russia is being subjected to ever-tighter economic sanctions. As a result, two large Asian countries are reducing their presence on the international trade landscape, creating an unprecedented scope for India to attract international firms to produce and export from here.

Exploiting this opportunity requires an appropriate policy stance. Perhaps the single most critical element of such a stance would be a stable and consistent trade policy. Whenever the government suddenly bans exports or imposes export duties, it puts firms with export orders in a position where they cannot fulfil their contracts. This is not only embarrassing, it also exposes both exporters and importers to large losses. To avoid this situation, domestic firms will shy away from entering the export business, while foreign firms will be reluctant to place orders with Indian firms. In addition, multinationals will be discouraged from shifting their production to India. After all, why should a firm relocate here, if there is a risk that its exports could be banned, its imports subjected to high duties, and the rules governing its sector changed overnight?

Similarly, sudden and radical policy announcements discourage investment. After two difficult pandemic years, the economy is now reviving, leading firms to consider whether now is the time to start increasing their production capacity. But firms will start to think again when the government alters policy frameworks overnight, even if the change is in a sector far removed from their own. The cost of major investments can only be recouped over a long payback period, and if over this timeframe the government takes an action that renders their investments uneconomic, the firms could end up in serious financial trouble. So better to play safe and avoid major investments.

Finally, the government's actions will affect growth in yet another way. The reduction in excise taxes on petrol and diesel will deprive the centre of revenue at a time when the budget deficit is already far too large. That means the government may need to compensate by cutting spending on infrastructure projects that are vital for the nation’s development.

At this crucial juncture, macroeconomic policy has the delicate task of simultaneously tackling inflation and promoting the recovery. The first task is the job of the RBI. The central bank must take full responsibility for its actions so far, sending a clear signal that henceforth it will focus on bringing inflation down without getting distracted by any other objective. The government on the other hand needs to focus on growth. It needs to reduce market interventions, eliminate prohibitions, and dismantle trade barriers, so that firms are incentivized to export and invest.

If instead, we continue to get the policy “assignments” mixed up, we will end up with objectives that are mixed up. That is, instead of entrenching growth and derailing inflation, we will derail the recovery and entrench inflation. That would not just be a policy mistake. It would be a recipe for a crisis.

4-point battle plan for RBI

Times of India, May 14, 2022

As the Indian economy struggles to recover from the pandemic, it is facing another obstacle in the form of high and rising inflation. Keeping inflation low and stable is the legal mandate of the Reserve Bank of India under the inflation targeting (IT) framework. It is therefore worth asking: why is inflation so high, and what should be done differently to ensure it comes down and stays down?

Consider the first question. In recent months, the Russia-Ukraine war and China’s lockdowns have pushed up the prices of critical items including crude oil, edible oils, and fertilisers. On top of that, for the first time in four decades, India is now “importing” high inflation from developed economies such as the US and Europe. Without doubt, these external developments have exacerbated India’s inflation. But they are not the cause of the problem.

The real cause of the problem lies closer to home. Inflation is high today because underlying pressures have been building up for years, and the RBI, despite its legal mandate, has not acted in time to stop them.

Since the start of the pandemic in March 2020, consumer price index (CPI) inflation has averaged 5.8 percent. This implies that inflation has been close to the 6 percent upper threshold of the RBI’s target band, despite an unprecedented collapse in demand. For the first three months of 2022, inflation has consistently exceeded the 6 percent upper limit. The wholesale price index (WPI) has been increasing at an even faster rate, averaging 13 percent since April 2021. This is the highest WPI inflation in more than two decades. This matters for the CPI target because persistent increases in wholesale prices get passed on to retail customers with a lag of a few quarters. Of particular concern has been the recent spike in WPI food inflation, which is now translating into high retail food prices.

In other words, the warning bells about growing inflationary pressures have been ringing loud and clear for a while now. Yet, despite being an IT central bank, the RBI has not been paying much heed to these alarm bells. On the contrary, it kept arguing that inflation was a temporary problem. This was presumably based on the assumption that inflation would disappear when the pandemic subsided, that the supply constraints--both domestic and international, would soon abate, and that global inflation was also temporary. The RBI’s inflation projections reflected this assessment. Over the past few months, its forecast of CPI inflation for 2022-23 remained in the range of 4.5 - 5.7 percent.

It is quite clear now that inflation is not a temporary problem. The war in Ukraine is unlikely to end soon, and even when it ends, the international sanctions on Russia will remain for some time. The lockdowns in China are getting worse by the day. Even the US Fed has now acknowledged that inflation is not a transient phenomenon and has been forced to act aggressively. In all likelihood, the era of low global inflation is now over.

Meanwhile, in India, with inflation predicted to subside on its own and remain well within the band, the RBI did not feel the need to act to contain it. Instead, its “accommodative” policy has trapped the economy in a vicious circle. With interest rates falling and inflation rising, real interest rates have been falling sharply, intensifying excess demand, feeding inflation, thereby further reducing real rates. During the first three months of 2022, real 91day Tbill rates fell to the exceptionally low rate of -2.6 percent. Clearly, the RBI needed to act on time to stop this dynamic.

This brings us to the second question: what should the RBI do differently to address this problem?

First, it needs to clearly communicate that it is serious about inflation and will do whatever it takes to bring inflation down to the target level over the next few months. This is important for anchoring inflation expectations. If the public expect inflation to keep rising it will become even more difficult for the RBI to tame inflation.

First, it maybe argued that the increased capex spending by the government since last year has not resulted in the desired “crowding-in” of private sector investment which continues to be sluggish.

Secondly, the RBI needs to stick to the operating procedure outlined in law, and announce monetary policy changes in a predictable manner. This is crucial for restoring its own credibility as an IT central bank. The surprise May 4 announcement, when the repo rate was suddenly raised by 40 basis points, is exactly the kind of policy action that the RBI should avoid. A sudden reaction like this sends a signal that the RBI has lost control of the situation and that after ignoring inflation for too long, needs to overcompensate. This kind of an action undermines rather than builds confidence.

Third, any decision to raise the policy rate must be accompanied by an inflation forecast that justifies the rate action. Releasing credible inflation forecasts instils confidence about the capability of the RBI to do IT.

Finally, the Monetary Policy Committee (MPC) should be restored to its rightful role as the overseer of policy decisions. Over the past few years, the RBI has essentially bypassed the MPC, thereby losing a vital “reality check” on its forecasts and actions.

The inflation problem in India has reached worrisome proportions. As a result, the adjustments needed are more painful than they would have been if the RBI had acted on time. But late is better than never. The RBI now needs to be decisive and resolute in pursuit of its inflation target. The future of India’s economy, and the livelihood of its people, depend on it.

Question of timing

Indian Express, May 31, 2022

The Reserve Bank of India normally makes policy announcements on a well-defined schedule. But on May 4 it unexpectedly tightened monetary policy, increasing its policy interest rate and reducing liquidity in the banking system. Markets were taken aback by the announcement, with the 10-year government bond yield jumping by 25 basis points to reach 7.38 percent.

Why did the RBI do this? Even after the Governor’s careful explanations, the answers remain unclear.

At one level, the answer is obvious: inflation pressures are rising. Since the last MPC meeting of April 8, headline CPI (consumer price index) inflation has gone up from 6.1 percent to 7.0 percent, and the forthcoming inflation numbers are expected to be even worse. Clearly, the RBI had to respond. So, it raised the policy repo rate by 40 basis points to 4.4 percent and increased the cash reserve ratio by 50 basis points to 4.5 percent.

This explanation however does not seem entirely adequate, because nothing fundamental has changed since the last policy meeting of April. Even back then, it was obvious that inflation pressures were rising. The wholesale price index (WPI) was already in double digits, inflation in the US and Europe was increasing, commodity prices were spiking owing to the Russia-Ukraine war, and supply chain constraints were tightening, as China imposed severe lockdowns to deal with a resurgence of the Covid-19 pandemic. But the RBI did not think that these pressures warranted a policy tightening.

What made the RBI change its mind? Under the Inflation Targeting framework, the central bank’s thinking is typically revealed by its inflation forecast. If it projects that inflation will be above target for some time, this implies that the central bank is concerned about rising prices and will be taking action to bring inflation down. In the last Policy Review, the RBI projected that inflation would abate to 5 percent by the end of the fiscal year, somewhat higher than the 4 percent objective but not unduly so, thereby explaining why the central bank saw no need to tighten at that time.

Presumably, the RBI now thinks that the inflation pressures will either be more intense or more durable than it had earlier expected. And presumably, the RBI felt that its policy stance was now “behind the curve”, meaning that urgent action was needed to quell these pressures. Otherwise, it would have waited till the next MPC meeting on June 8 to increase the repo rate. But it is impossible to know whether this was really the motivation, as the RBI didn’t release a revised inflation forecast—and because other explanations are also possible.

One possibility relates to the exchange rate. The US Federal Reserve was expected to announce a 50 basis point increase in interest rates later in the day of May 4. So, it is possible that the RBI wanted to jump ahead of this announcement by announcing its own 40 basis point rate increase, maintaining (more or less) the interest differential against the US dollar and thereby keeping the dollar-rupee exchange rate relatively stable.

It's not obvious why exchange rate stability would be a priority for the RBI. After all, its legal mandate is to achieve an inflation target, not an exchange rate objective. But the RBI does seem determined to limit the rupee’s depreciation. The April 8 statement highlighted that India's foreign exchange reserves had increased to US 607 billion at the end of 2021-22. In contrast, the May 4 statement mentioned that India’s foreign exchange reserves now amount to US 600 billion, a decline of US 7 billion. So, clearly the RBI has been intervening in the foreign exchange market to stem the rupee depreciation. It therefore appears plausible that the unexpected increase in the policy rate was done to defend the currency against further depreciation pressures.

So, there are two potential explanations for the RBI's sudden move. Both have rationales, but both also have costs. Consider the first possibility, that the RBI has now radically revised its inflation forecast (without of course releasing the same). Inflation targeting works best if monetary policy is predictable, with interest rate actions being announced on a regular schedule, based on clearly-explained inflation forecasts. On the contrary, sudden moves convey the message that the RBI is getting worried that it is no longer in control of the inflation situation, which is hardly a reassuring signal to send to the markets.

Next, consider the possibility that the RBI wanted to keep the exchange rate stable. The problem is that India is facing an adverse terms of trade shock in the form of rising oil prices, which is putting pressure on the current account deficit. If the RBI allowed the exchange rate to depreciate in response, this would alleviate the current account deficit. Perhaps more importantly, depreciation would help the nascent recovery by ensuring that exports can continue to grow, despite the difficult international circumstances. And there is the additional problem that targeting the exchange rate violates the RBI’s legal mandate.

The RBI now faces a difficult task in the months ahead. At the broadest level, it needs to address the costs of its surprise announcement by reinforcing the credibility of the inflation targeting framework. Specifically, it will need to focus – and be seen to focus – squarely on its inflation target, rather than exchange rate or other objectives. And it will need to convince the public that it is actually trying to get inflation under control.

To do this, it will need to continue to tighten policy – but in a gradual, predictable and transparent manner.

Why RBI must heed inflation

Indian Express, March 29, 2022

The Reserve Bank of India is an inflation targeting central bank. It is legally mandated to keep inflation in check. Yet the RBI has persisted with its easy monetary policy, even as inflation pressures have increased. We need to understand why, and what could be the repercussions.

Let's first ask, is inflation a problem in India? Indeed, it is. For most of the past two years, CPI (consumer price index) inflation has been hovering close to the 6 percent upper threshold of the RBI’s target band. Inflation averaged 6.1 percent during the pandemic period (April 2020 to June 2021), despite a massive collapse in aggregate demand. It then dipped somewhat as food prices eased, but underlying inflation (i.e., core inflation, excluding food and fuel items) has remained around 6 percent for the last twelve months. Then in January 2022, as food prices recovered, headline inflation once again crossed the upper threshold of the RBI's inflation targeting band.

Inflationary pressures do not seem to be diminishing either. Instead, they continue to build up. The standard measure of inflation "in the pipeline" is WPI (wholesale price index) inflation, since price increases at the wholesale level tend to translate into retail inflation in due course. And the WPI is sounding a loud alarm. Between April 2021 and February 2022, WPI inflation averaged 12.7 percent, the highest in more than a decade.

The problems do not stop there. Russia’s invasion of Ukraine has resulted in a sharp increase in global commodity prices, including prices of crude oil, edible oils, and fertilisers. At the same time, a resurgence of the Covid-19 pandemic in mainland China and Hong Kong has led to shutdowns that will further constrain supplies of raw materials. Even if the war and the pandemic in China both subside soon, their effects will not. Sanctions on Russia are likely to remain for some time, while it will take a while for China to clear the backlog of orders that the shutdowns have caused.

Indian firms are already adapting to this situation, passing on the commodity price increases to retail prices. We have reports of double-digit increases in the prices of consumer goods (FMCG) as well as in the real estate sector. Even though the government continues to suppress domestic pump prices, prices of petrol, diesel and cooking gas have gone up in major cities.

Standard economics gives us a guide for how central banks should react in a situation like this. It says that monetary policy should accommodate the first round of commodity price increase, but only under certain conditions, notably that inflation is initially on target, and expectations are firmly anchored. But neither condition holds at present. Inflation is already too high, and so are expectations. As of January 2022, 68 percent of households surveyed by the RBI expected prices in the 1-year ahead period to increase more than the current rate, up from 63 percent one year ago; more than 57 percent households expected cost of services in the 1-year ahead period to increase more than the current levels, up from 51 percent one year ago.

In some quarters, an argument is nonetheless being made that monetary policy should not be tightened when inflation is driven by supply-side factors, as it can adversely impact growth. This is fallacious; it has things exactly backward. When there are supply constraints, using easy monetary policy to boost demand is not going to boost output. It will only create a situation of excess demand, pushing up prices even further. And if firms are expecting high inflation, this will send things into a vicious spiral, as they will increase their prices even more in advance of any input price pressures.

Surely the RBI is aware of all of this. So why is it still not acting on it? To answer this let’s take a step back and look at what is happening globally.

The RBI is not the only central bank that is not reacting to inflation. In the US, the Federal Reserve has been slow to raise rates even as inflation has reached a four-decade high. The ECB in Europe has been even slower to react. The problem seems to be that governments all over the world are worried about growth. They are hoping that central banks can somehow solve this problem, since government debts are at exceptionally high levels. Until governments accept that reviving growth is their responsibility, not that of the central banks, and especially not when inflationary pressures are on the rise, central banks will not be able to focus on inflation.

In India, monetary policy also suffers from a strong fiscal dominance. As a result, not only is the RBI expected to support growth, it is also expected to keep the government’s borrowing costs in check, which is in direct conflict with its inflation targeting objective.

What are the repercussions of the RBI ignoring inflationary pressures? A decade ago, we were in a similar situation where inflation had started increasing but the RBI delayed its response because it was focusing on growth. When inflation subsequently took off, it reached double digits and the RBI had to raise interest rates aggressively to bring it down. That was a very painful adjustment. We do not need a repeat of that episode now. In other words, we need to recognise that high inflation is the real threat to growth, not a prudent monetary policy tightening.

In addition, if the RBI does allow inflation to take off, there will be long-lasting repercussions for the credibility of the RBI. Inflation control requires anchored inflation expectations. But if the public see the RBI consistently ignoring inflation, expectations can rapidly get unanchored and then it becomes very costly to bring inflation down.

In summary, inflation is best addressed by the central bank using monetary policy, not by the government adjusting taxes. The RBI needs to urgently revisit its inflation forecast and its monetary policy stance in order to avoid potentially painful adjustments down the road.

Monetary policy: Losing clarity on instruments and goals

(with Harsh Vardhan), Times of India, February 15, 2022

After the Union Budget, economists as well as financial market participants eagerly waited for the Reserve Bank of India to announce its strategy for the coming fiscal year. On February 10, the Governor and the Monetary Policy Committee (MPC) duly outlined their approach. These statements, however, only raised more questions than they answered.

Before the pandemic began, monetary policy was straightforward. The RBI’s objective was clear, as it had a legal mandate under the Inflation Targeting regime of ensuring that consumer price index inflation remained within a 2-6 percent band. Accordingly, at each Policy Review the MPC would set the repo rate at the level it thought would be sufficient to achieve this target. All other interest rates were sideshows, because they were automatically adjusted whenever the repo rate was changed.

Since the pandemic however, the RBI’s operational strategy has changed dramatically. The repo rate has ceased to be the policy instrument, being replaced by the reverse repo rate, i.e. the rate at which banks park their short-term liquidity with the RBI. At the same time, other rates have become detached from the policy rate. So, there is no longer one clear measure of the policy stance, making it difficult to understand what strategy the RBI is pursuing.

After the February 10th review, this confusion has only deepened. Here we highlight four areas of particular ambiguity.

First, it is unclear whether the RBI is maintaining its stance – or tightening it. The official settings have not been changed. But at the same time the Governor emphasized that the effective reverse repo rate has increased from 3.37 percent in August 2021 to 3.87 percent in February 2022, suggesting that behind the scenes policy is being tightened.

How is the RBI doing this? Over the past few months, it has introduced a new facility, the variable reverse repo rate (VRRR) auction. The RBI is now absorbing liquidity under two facilities at two different prices – the reverse repo, with a rate of 3.35 percent, and the VRRR, with a rate of 3.87 percent. Markets expected this anomalous situation to be regularised at the Policy Review, through an increase in the reverse repo rate. But this did not happen. So markets are now confused: what is the RBI’s policy rate?

Second, markets are confused about the RBI’s liquidity stance. During the pandemic period, the RBI injected massive amounts of liquidity into the banking system by buying government bonds, and then stopped as the situation improved. Presumably, the next step would be to wind back the excess liquidity it had created. That would require selling some of the bonds it has accumulated, putting upward pressure on the rates on government securities. Alternatively, it might want to contain G-Sec rates to support the government’s large borrowing programme, but this would entail buying more government bonds, adding to the excess liquidity and risking higher inflation. So, which way is the RBI planning to go? The RBI did not say.

Third, the RBI tried to shed some light on its stance by stating that it will remain accommodative. But this statement has been stripped of much of its meaning. The RBI’s stance has remained “accommodative” across the last 12 meetings, even as it has gone from reducing the reverse repo rate to raising the effective rate, and from injecting liquidity to containing liquidity. So, what precisely does "accommodative" mean?

Finally, the RBI has indicated that it is comfortable with the inflation outlook, predicting that CPI inflation will be 4.5 percent in 2022-23. But can it really be that comfortable? Developed countries are experiencing their highest inflation in four decades, with inflation in the US now running at 7.5 percent. As a result, India faces the risk of importing high inflation. In particular, since the last time retail oil prices were raised, global crude oil prices have increased from USD 75 to USD 90 per barrel. If this increase is passed on to consumers, inflation is bound to rise.

Meanwhile, the Union Budget has announced that it plans to stimulate aggregate demand by increasing capital expenditure, at a time when private sector activity has started to revive. But if the pandemic continues to restrain supply, a significant increase in aggregate demand will only intensify inflationary pressures.

So, there is a real risk that inflation will be far higher than 4.5 percent. If so, what will the RBI do? Again, the market has no idea.

The end result is considerable confusion. It is unclear whether the RBI is committed to low inflation – or to coming up with highly dovish forecasts in order to support the government’s stimulative policy. Nor is it clear what the instruments of monetary policy are, as the repo rate and now the reverse repo rate have lost relevance. So what is the policy rate, and where is it heading? No one knows.

The Governor quoted a line from the late Ms Lata Mangeshkar’s famous song "Aaj Phir Jeene Ki Tamanna Hai". It is wise for us to remember the second line of the song “Aaj Phir Marne Ka Iraada Hai” and note that Tamanna means desire and Iraada means intention!

Budget 2022-23: Hits and misses

Budget 2022-23: Hits and misses, Ideas for India, February 14, 2022.

RBI’s dilemma: Let prices rise or interest rates?

Times of India, February 8, 2022

One of the striking features of the Union Budget was the high borrowing requirement. The government plans to borrow Rs 15 lakh crore in 2022-23, to finance a higher-than-anticipated fiscal deficit of 6.4 percent of GDP. This decision will complicate the policy choices for the Reserve Bank of India.

During the two years of the pandemic, when the government’s borrowing requirements increased manifold owing to high fiscal deficits, the RBI stepped in to make it cheaper for the government to borrow. It lowered the short-term policy repo rate to a mere 4 percent in March 2020. Then, through a series of unconventional actions, it bought immense quantities of government bonds and injected vast amounts of liquidity into banks, to encourage them to buy bonds as well. As a result of these actions, the rate on 10-year government securities fell to 6 percent, even as inflation kept increasing.

The increase in inflation was fairly modest, considering the extent of the RBI’s actions. In ordinary circumstances, a large increase in liquidity would encourage banks to open the credit taps, allowing firms and households to step up their spending, which would then cause inflation to soar. But during the heightened uncertainty of the pandemic, banks were reluctant to lend, households were disinclined to spend, and firms were hesitant to embark on investment projects. As a result, spending was contained. CPI inflation reached the upper limit of the RBI’s target band, but did not spin out of control.

This situation made life easy for the official sector. The government could run large deficits and the RBI a stimulative policy, without worrying about the consequences for inflation. Even better, the advanced countries were pursuing similar policies. This in turn encouraged capital to flow to emerging markets, providing India with additional liquidity and reinforcing the RBI's strategic objectives.

However, in recent months, the global macroeconomic environment has changed quite significantly. After years of price stability, developed countries are experiencing a serious bout of inflation. Inflation has jumped to 5 percent in Europe and 7 percent in the US, the highest in four decades. This change has two implications for India.

First, for the first time in decades, India is now faced with a serious case of "imported inflation". Prices are rising rapidly on all the goods India imports, from oil to investment goods to vital industrial inputs. Even food prices have increased by 20 percent year-on-year as measured by the FAO Food Price Index.

Second, as a result of this global inflation, developed country central banks are getting ready to increase interest rates and withdraw the additional liquidity they had pumped into the system during the last two years. As a result, their policy has begun to diverge from the RBI’s accommodative stance, prompting capital to flow out of India in copious amounts over the past two months. This has weakened the rupee and pushed up domestic bond rates.

With foreigners fleeing the Indian market, domestic institutions panicked when they found out about the Budget borrowing plan, because it meant that they might have to shoulder the entire burden of absorbing the Rs 15 lakh crore that the government is planning to issue. In addition, they would also need to buy whatever amount of government securities the foreign investors are planning to sell in the coming months. Unsurprisingly, the 10-year rate has shot up to 6.9 percent in a matter of days.

This brings us to the RBI. Given the changed global environment and the government’s big borrowing plan, the RBI is faced with two difficult policy options, each with associated risks.

It could resume buying government securities in order to keep interest rates in check. The problem is that buying bonds will inject even more liquidity into the system, at a time when price pressures are intensifying. This could potentially jeopardize the RBI’s objective, since CPI inflation is already running close to its legally mandated limit.

Alternatively the RBI could wind back liquidity and raise the policy repo rate. This would be consistent with its inflation targeting objective, and bring its stance in line with that of the developed countries, thereby reducing the risk of further capital outflows. But it would also push up bond rates, making it costlier for the government and the private sector to borrow.

Both options have their costs. But between the two, the RBI should worry first and foremost about the costs to society of high inflation. Inflation is a tax that falls heaviest on the poorest, the most vulnerable segment of the society. And once inflation starts rising, it becomes very difficult and costly to bring it down, as we learned from our painful experience during 2013-14, when short-term interest rates reached 12 percent. As for bond rates, ultimately they need to be determined by demand and supply, without interference from the central bank, as this is the only way to ensure that they reflect the real cost of capital.

It will be interesting to see which way the RBI goes.