Inflation takes an ugly turn: What should RBI do now?

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The ugly double digit inflation numbers for May have taken the markets by surprise. We have lived out this entire week fearing central bank action. And, the big question remains, what the RBI should be doing?

C Rangarajan, Former Governor of the RBI says, "The inflation rate has reached a very uncomfortable level. The double digit inflation has now remained for almost two to four months and therefore it can no longer be treated as purely triggered by food inflation because the manufacturing sector is also showing reasonably high degree of inflation-about 6% or in fact over 6% and therefore some action in the demand side is called for. It is up to the Reserve Bank to take action whether immediately or a little later but I think the question of taking some action in terms of tightening the policy has become imperative."

KC Chakrabarty, RBI Deputy Governor is in complete agreement with Rangarajan.

Meanwhile, Ajay Shah, Senior Fellow at NIPFP, believes that we should not be looking at a year-on-year inflation which is the average of what happened in the last 12 months. "We should be looking at the month-on-month seasonally adjusted changes. With this, things are not that troublesome in February and March, we have got one big number in April. That is indeed a problem and is worrisome. But I would argue that we need to see a little more evidence and we need to gain confidence that we have a significant upsurge of inflation on our hands."

Further he adds, "You have to remember that the currency depreciated to some extent between April and March, so to some extent the April inflation is just a mechanical reflection of exchange rate passed through. When the currency depreciates, all tradable goods become costlier so it may not yet convey a significant process of domestic inflation."

Yes the central bank has a tough problem. Global markets are fragile and domestically there is a short term liquidity crunch and the RBI needs to protect the growth impulses from both these. But when inflation is at 10% and growth at 8.6%, the RBI signaling rate at 3.75% gives a seriously negative real interest rate situation. And that has been the situation for quite some time now. The RBI cut rates way too sharply during the crisis of late 2008 and although the economy has rebounded speedily, the RBI has not brought back rates even to normal levels. It simply has to act, and may be it will next week.