Talking of a roadmap (INDIAN EXPRESS)

The Reserve Bank’s focus on inflation and its approach to the role of inflation in determining the investment climate of a country is new and welcome. There is often a misconception that raising interest rates is bad for investment, and therefore if investment slows down interest rates should be cut. However, investment decisions are based not merely on interest rates and the cost of capital but also on the cost of inputs on the one hand and output on the other. Profit expectations depend on expected prices and when inflation is high and volatile, then both input costs and output costs become less predictable and the risk associated with the project goes up. Cross-country evidence suggests that high and volatile inflation causes investment to slow down. This has led to a focus of monetary policy on keeping inflation low and stable.


This thinking is reflected in the RBI’s monetary policy statement. It raised interest rates by 50 basis points in an attempt to rein in inflation. RBI Governor D. Subbarao remained focused on inflation and did not let up because of the slowdown in output observed in recent months. Indeed, he said that the RBI is strongly of the view that controlling inflation is imperative for both sustaining growth over the medium-term and increasing the potential growth rate. This is a critical attribute of a favourable investment climate, on which the economy’s potential growth depends.


The problem at this stage, when inflation has been persistent, is that the rate hike may not be sufficient. First, fiscal deficits are large and there is little expectation that these will be reined in. Second, interest rate hikes are only one element of a successful monetary policy strategy that can effectively control inflation. Equally important, as has been understood in the last 20 years in countries that followed price stability as the main objective of monetary policy, is that the central bank be credible in its commitment to price stability and that it communicate this effectively to the public. Often central banks have shed other conflicting objectives, however important they may seem, in order to gain this credibility. They then tirelessly communicate with the public about their monetary policy strategy to effectively impact expectations about inflation. The RBI should use every opportunity to do the same. Until inflation reaches the RBI’s desired 4-5 per cent level, it should constantly articulate how that target is going to be achieved.