Saturday, May 06, 2006

Was a rate hike required?

A few weeks ago, there was a great deal of focus on whether the RBI should have raised rates. I wrote an opinion piece in Business Standard where I argued that in response to the recent spike in CPI growth, and in response to the expected inflation of coming months, there is a need to raise rates now.

My reasoning is based on the `Taylor Principle' which suggests that monetary policy has to respond by more than one-for-one when there are changes to expected inflation. The trouble is: we don't measure inflation well, and there is no secondary market for inflation indexed bonds using which we can infer inflation expectations. So the question really turns on your views about inflation.

My view is that the CPI is the best inflation measure in India (and the WPI is worse than useless - your understanding of India goes down if you listen to the WPI). And, lacking either the models or the inflation-indexed bonds, I fall back on mere extrapolation. The acceleration of CPI is clear, and further oil-induced inflation is likely.

Of course, none of this makes much sense as long as we have a pegged exchange rate, for the RBI doesn't really run an Indian monetary policy as long as the exchange rate is pegged to the USD. I guess my point is that we need to bring a new monetary economics to bear on Indian monetary policy, instead of giving over the job to a mechanical currency peg.

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