The RBI signalled last week that it would tackle inflation head-on. The 50 bps hike in the repo rate was meant to send a strong signal to the market.
When inflation has been in the double digit range for two years running, the central bank has little choice. But, then, we need to be clear that high inflation in the recent past has been driven primarily by supply-side factors, fuel and food prices. Both these will stay at elevated levels in the coming months. Further, there is evidence that variations in demand in the period 2006-10 had little bearing on the inflation rate, particularly variations in non-agricultural GDP.
What role can demand management by the RBI play in such a scenario? It may not be able to influence demand but it can still influence the inflation rate by anchoring inflation expectations. That is what the RBI is seeking to do. If that is so, what expectations of inflation should the RBI target? In other words, what rate of inflation should we tolerate in the present scenario? It cannot be the previous comfort rate of 3-4%. It has to be something higher. The RBI needs to indicate what that is. Compressing demand to reduce the growth rate can otherwise end up inflicting costs on the economy that are greater than the costs imposed by high inflation.
More in my ET column, A 'new normal' for inflation?
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