RBI should hike rates now to fight inflation: NIPFP

He feels that the way monetary policy is being handled is the reason behind India's inflation woes. "Inflation is finally and in the long term always a monetary phenomenon. We have been above the 5% upper threshold of CPI inflation in every single month from February 2006 onwards. This is not a short, quick, temporary burst of inflation. This is deeper monetary policy problem."

Below is the edited transcript of Shah’s interview with CNBC-TV18. Also watch the accompanying videos.

Q: First up your comment on the Reserve Bank action or lack of it, lack of an expected rate cut on June 18th that has been you advice isn’t it?

A: No. I would have been horrified if there had been a rate cut. I personally think that it is time to raise rates. It is time to fight inflation, so I was quite surprised and concerned when there was 50 basis point rate cut in April.

Q: You would have been horrified at the GDP numbers as well at 5.3%. You have perhaps correctly distrusted the exact GDP numbers but surely the direction is lower and lower and getting rather bad?

A: There is no question that we are in the midst of a downturn. Things are difficult in output. Now the question arises - what can we do about it? I would continue to worry that high and unstable inflation is part of the malaise.

High and unstable is what is making it difficult for the firms to do their planning, to undertake investment and to be able to function harmoniously. So, if we want to set the platform for high and sustained growth, one of the elements of that platform has got to be a sustained war on inflation.

Q: What exactly is your view with regards to inflation with the CPI data as well as WPI? One of the views that came out from the economist table that the MSP increase of around 20% was the reason why the RBI possibly held off because there is a higher risk in terms of food inflation going forward. How exactly do you expect the trajectory on inflation to pan out for 2012 and possibly FY13?

A: We seem to be stuck in a spiral of a roughly double digit inflation. For months and months we are persistently in the roughly 10% CPI inflation range, I only look at the CPI. CPI is the inflation that matters to the household.

Household expectations are saying 12-13%. I would be thrilled and delighted if this inflationary tiger would just rollover and be nice but that is not what history teaches us. When a country gets into an inflation crisis, inflation does not subside all by itself.

Q: One would have thought that the political authorities would be the natural hedge against inflation because it is politically suicidal to have double digit inflation for three-four years in a row as you correctly point out. Yet, quite clearly the biggest problem for inflation I think is the fisc which is generating this aggregate 6% of GDP in the form of aggregate demand and probably fuelling inflation. What is your diagnosis of this four year old problem?

A: I am no admirer of the way India is handling fiscal policy, but we should be careful in how we thing about it. The exchequer will do what the exchequer must do. In lots of countries in the world, you have various fiscal problems. So, India is not alone in having fiscal difficulties. I would also point parenthetically that India has had sustained large fiscal deficit. So, in a way you want to explain the inflation crisis which is from 2006 onwards.

I am not so sure if you can pin it on the fisc because fiscal policy has been misbehaving for a very long time. Monetary policy is and should be the main story about inflation. The rupee is the invention of the Reserve Bank of India and maintaining the length of the rupee is the core business of the Reserve Bank of India. So, there is a split and that split is important. The exchequer will do what the exchequer must do.

We can advice the exchequer. We all have our views about what fiscal policy should do. I do not support large fiscal deficit. But let’s not lose sight of perspective. Inflation is finally and in the long term always a monetary phenomenon. Inflation is about the length of the rupee. The rupee is a creation of the Reserve Bank of India.

You do not get year to year fluctuations in fiscal policy or monsoon or whatever generating long term sustained inflation. Remember, we have been above the 5% upper threshold of CPI inflation in every single month from February 2006 onwards. This is not a short, quick, temporary burst of inflation. This is deeper monetary policy problem.