Anchoring Inflation Expectations :

The annual monetary policy statement for 2011-12 shows a new realism about inflationary pressures.

Inﬂation needs to be kept under check for sustained growth and to prevent deterioration in the already low living standards of India’s poor. Inﬂation expectations actually need to be anchored at a low and moderate level, as rising prices beyond a point feed on themselves. Both – inﬂation and inﬂation expectations – are conditioned upon, ﬁrst, a clearly stated inﬂation objective for macroeconomic policy and management, particularly for monetary policy, second, a credible use of instruments available with public authorities, operating in particular the appropriate instruments of monetary policy, and, third, ensuring the effective transmission of such policy instruments.

Though controlling inﬂation is considered to be a prominent objective of the central bank, the resolve to contain rising prices has to come from both the central bank and the government. This is so because supply-side constraints can be addressed only by the government. But a show of resolve by the central bank is crucial since the government is subject to pressures and ﬁscal compulsions in electoral cycles. Given these factors, the announcements in the annual monetary policy for 2011-12 by the Reserve Bank of India (RBI) governor Duvvuri Subbarao mark certain decisive steps forward. The ﬁrst is the 50 basis points increase in the policy rate which departs from the previous “baby steps” in this regard. The second is the certainty signalled by making the repo the sole policy rate. The third is the creation of the new Marginal Standing Facility from which banks can borrow at the repo plus 100 basis points. The changes in the operating framework will give a certain leeway to RBI in managing liquidity more actively. It should really place RBI as the lender of the last resort, rather than the central bank being a borrower of the ﬁrst resort. That the transmission of the policy rate has been effective is borne out by the fact that soon after the policy announcement, many banks revised their base rate for lending by 50 basis points.