This article is on the role of the Reserve Bank of India (RBI) in managing inflation, interest rates and exchange rates. At stake are four inter-related issues.

• First, what is the actual impact of growth in money supply on inflation in India, with what lag, and on what items?
• Second, what is the extent to which tighter credit policies and harder interest rates affect domestic demand, investment and growth?
• Third, in an environment of unprecedented portfolio capital inflows, can we credibly regulate the rate of exchange rate appreciation?
• Fourth, in a world where capital flows at the click of a mouse, is it possible for a central bank to simultaneously manage money supply, interest rates and exchange rates, especially with huge dollar inflows?

Let us examine these in reverse order. The answer to the fourth is an unambiguous negative. In an open economy with significant capital convertibility, interest rates and exchange rates are co-determined. One can’t fix one without affecting the other. And this interdependence gets heightened in an environment of massive capital inflows — where any significant action to curb inflation by sharply controlling money supply will rapidly affect the other two variables. The greater the amount and velocity of capital inflows, the bigger the problem of controlling the triad — money supply, interest and exchange rates.

The third issue is more complicated. To regulate the rupee from appreciating ‘too much’, the RBI has to steadily buy dollars. That immediately increases money supply; and an inflation sensitive central bank then has to suck out the extra money by auctioning government securities (g-secs). It also has to invest the dollars in US treasury bills (t-bills). Since the interest on US t-bills is lower than that on Indian g-secs, there is a hit on the books. However, I have argued that the financial hit is trivial compared to the effects of a sharply appreciating rupee on the real economy. I believe that the RBI has recently come around to the same view — namely, intervene every so often to keep a lid on exchange rate appreciation, and take a knock on the cost of sterilisation. Which is why, despite continuing inflows, the rupee has been of late hovering around Rs.39.25, and not breached the Rs.39 mark.

In controlling exchange rate appreciation, a major concern is credibility. How long can the RBI consistently buy dollars, or wink at major banks to do so? Can the pattern of intervention be gleaned by major currency traders? And if the RBI lets go — even for a few days — will the exchange rate overshoot to intolerable levels?

Regarding the second issue, it is clear that the tighter credit and harder interest rates are biting. Consumer credit has reduced sharply; housing demand is down; smaller firms are facing much higher working capital costs; larger companies are cutting their original investment plans. I wouldn’t be surprised if we see a 1.5-2 percentage point drop in the growth of industrial output. We are a stage where high real interest is choking growth.

The relation between money supply growth and inflation is the trickiest. There is no recent definitive work that shows how growth in money supply affects inflation; with what lag; and over what class of goods and services. Our guideposts are guesses, hunches and dated, shoddy empirical work. Clearly money supply growth doesn’t affect the prices of onions, potatoes, edible oils or foodgrain. Nor does it affect globally traded minerals, hydrocarbons or metals. My hunch is that inflation in India is far more supply determined than what the RBI believes.

In this milieu, there are no set formulae. We are in uncharted waters. The RBI needs to craft finely calibrated responses, learn from small errors, make little moves every now and then; to ensure that somehow the exchange rate doesn’t appreciate alarmingly; that the interest rates get gradually softened; and that money supply fuels growth instead of inflation. It is a difficult act of continuously adroit manoeuvring. The good thing is that the RBI is learning the ropes. And realising that the times require learning from unlearning… not from dead certainties.
 
Published: Business World, November 2007