Just as RBI governor Y V Reddy was getting ready to announce the annual policy today, the prime minister made inflation the central theme in his address to an industry body in the capital.

Like the heads of government are expected to say at such occasions, he claimed the government was on the job and was confident of bringing down inflation. Then, as most politicians do in all occasions, he set out to lay part of the blame for inflationary pressures on external factors over which his government has no control. He then broadened the discourse and said the world community has not done enough to address the challenges of rising food and energy prices.

Governor Reddy has also blamed external factors in the recent past for the rise in domestic inflation. But, being the central bank governor, he has to come up with specific policy responses to address the situation. It is not easy being a central banker these days as Ben Bernanke will readily agree. Even the legacy of the once infallible Alan Greenspan is now being questioned, perhaps rightly so.

The rock……..

Until this February, inflation was nobody's concern. After going down very close to 3 per cent, mid-way through the last financial year, inflation inched up during the last quarter. But, it was still within the RBI's comfort zone. The only major worry was the impact of the fuel price adjustment, as and when it happened. In any case, fuel prices were not expected to be hiked substantially and hence the impact was considered to be minimal.

The fuel price hike was quite modest when it happened, but something else gave away. Food prices started shooting up, in line with international trends. Prices of commodities, especially metals, firmed up even further. The government swung into action and cut import duties, banned exports and commodity derivatives and, in sheer desperation, renewed the bullying of steel and cement manufacturers to hold prices.

By March, inflation seemed to be going out of control and rose to a three-year high of nearly 7.5 per cent. Governor Reddy was not very happy and said inflation was 'unusually high' and unacceptable.

The trouble with inflation is that it is universally seen as one of the most politically sensitive issues. Our parliamentarians may create some muffled noises if economic growth slows down. National income aggregates can be a bit unwieldy to get a good grip on and not many politicians take a lining to them. But, they are ever willing to create a melee if prices increase even slightly and are seen to be threatening the blissful world of the aam aadmi voting class. 

Given this hyper-sensitivity to price levels in popular democracies, the central banks also tend to give more significance to inflation fighting. While an obsessive focus on inflation is not the ideal policy prescription, under political pressure, central bankers end up worrying more about inflation.

The RBI now expects inflation to average 5.5 per cent during this financial year, higher than its stated target of 5 per cent for the last year. Most economists expect inflation to average nearly 6 per cent during the first half of this year. That means, there has to be a significant moderation in inflation in the second half to meet RBI's forecasts.

A very good monsoon will definitely help in bringing food prices down and ease inflation. Yet, crude oil prices will remain a major concern. After averaging below $80 per barrel during the last financial year, the Indian crude oil basket has moved close to $110 per barrel now. Though it is unlikely that the government will increase fuel prices before the elections, even if the oil companies bleed to death and the fiscal deficit worsens, the RBI will have to factor in a potential fuel price hike while calibrating its policy.

………and the hard place
Until last month, most commentators, economists and newspaper editorials were categorical that the RBI must cut interest rates. The reasons were easy to find, the slackening growth momentum, global credit market troubles, the equity market meltdown, easing property prices, slowing credit demand and so on. The US Fed was throwing everything at its disposal – sharp rate cuts, lending to banks and even brokers in need of money - to avoid financial meltdowns and prevent the US economy from going downhill.

Industrial growth had slumped to half the levels seen during the first half of the last financial year. The argument in favour of the rate cut seemed persuasive enough and it was widely believed that it was only a matter of when, and not whether, the RBI moved in that direction. When the central bank did not budge and kept the rates unchanged, it was interpreted as being overcautious. Sooner than later, the RBI will have to follow the trend set by the central banks of mature economies – read the US Fed – was the common refrain.

As the dark clouds were gathering over the economic horizon, only the finance minister and the forecasters at CMIE remained unmoved and continued to proclaim that there was no slowdown. The latter went a step ahead and forecast 9.5 per cent growth for the current financial year (See:Economy to grow at 9.5 per cent in 2008-09: CMIE).

But, the finance minister's usual optimism seems to have been slightly dented. He has lowered his growth expectations for the current year to around 8 per cent, a significant climbdown from his earlier predictions.

On its part, the RBI now expects 2008-09 GDP growth to be between 8 and 8.5 per cent. That is still above the consensus estimate which is below 8 per cent and the IMF forecast of 7.9 per cent.

These forecasts are assuming a short recession lasting just two quarters in the US, barely enough to formally qualify as a recession, followed by a quick recovery. In that scenario, global growth will not be affected significantly and the emerging economies will continue to roar.

But, there is a growing camp of those who believe that the US recession may in fact be deeper and last longer. Billionaire speculator George Soros was the most prominent member of this camp until recently. The latest entrant is none other than Warren Buffet and his entry should attract more converts in the near future. He is the world's richest man for a reason and people wait to hear him speak.

If this scenario plays out, we are definitely in for more trouble. A long drawn out recessionary phase in the US, even if a few quarters show positive growth in between, may pull down global growth even further. That will be an even harder place for central banks, including the RBI.

The in-between option
When faced with difficult choices, we all try to wriggle out of the situation. The more patient and judicious will take just the minor steps essential for survival and wait for better clarity before making a major move. That is precisely what the RBI has done with the CRR hike.

A CRR hike is a 'neither here, nor there' option and is often labelled as a blunt tool. It does not necessarily signal a policy shift like an interest rate hike will and hence may not be all that effective. All it does is soak some money supply, every 25 basis point hike absorbs around Rs9,000 crore from the banking system. Including the 50 basis point hike announced earlier this month, the CRR has been increased by 75 basis points and now stands at 8.25 per cent.

The trouble is, the CRR has been RBI's preferred policy tool for many months now. With repeated use, the blunt instrument has become even duller and subsequent policy moves risk being seen as procrastination on the part of the central bank. It is important for central banks to be seen as decisive, for the policy tools to have the desired effect.

In a recent speech, the governor rightly pointed out that the RBI has no specific mandate for price stability or inflation targeting. The central bank's mandates have evolved over a period, which gives it enough flexibility to decide on the relative emphasis between the objectives of price stability and supporting economic growth. But, that phase may have come to an end in this cycle. The RBI will find it increasingly difficult to continue fiddling with the CRR and will be forced to make a choice between containing inflation and avoiding further growth deceleration. Sooner than later, governor Reddy will make his move and don't be surprised if he decides to take rates higher.