Inflation: will raising key rates do the magic

With inflation running out of control and inflationary expectations getting stronger in the economy RBI is faced with a policy dillema for its sheduled quarterly monetary policy review on 25th January 2011. While on the one hand the economy is liquidity starved and the banking system has been estimated to be short of  1 Thousand Crore of liquidity on the other hand economy is facing galloping inflation which has lead to building of strong inflationary expectation and shaken foreign investors confidence. If India has to remain hotspot investment destination it needs to tame the monster of inflation. Inflation needs to be controlled to provide relief to common men and provide stability to the economy. However, it is also true that the economy requires liquidity to sustain the growth momentum and the industrial sector requires credit more so in the context of moderation in industrial growth for quarter ending December. There is huge pressure on RBI from the bankers lobby to reduce the key rates at least by 25 basis points. To temporarily deal with liquidity shortage RBI has allowed banks to maintain SLR at 24% despite keeping it at 25%. However, the monetary policy dictates say it is time to raise key rates and RBI is expected to raise them unconventionally by 50 basis points instead of raising them by 25 basis points in a phase wise manner.

The question that arises is that can this inflation be tamed by monetary actions as it seems to be driven by supply side bottlenecks. The source of it is the agricultural sector and food inflation is a major contributor to the inflation rally on which RBI has very little  control. A rise of 50 basis points is not going to do much to tame inflation and its major role would be to check inflationary expections from getting stronger and weaken the chance of a wage price spiral. To bring inflation back to a desirable level however govt. intervention is very necessary. Reduction in fiscal deficit, proper channelization of subsidies to reach the actual target, improving the food grain procurement and distribution system are some measures required to be taken. However, what is requred immediately is that govt. releases some portion of its buffer stock in the open market to control food prices and increase raids to force dehoarding. Rest, India is an agricultral nation and this is to be proven yet again when to get relief from inflation we need to wait for the end of rabi season of Indian agriculture and hope for a good harvest. This is our only hope at present. As for industries they will have to survive in a liquidity starved situation for few more months.