R Jagannathan
Firstpost.com
Why has the rupee strengthened when its purchasing power continues to fall continuously and swiftly? At last count, both the wholesale and consumer price indices were moving firmly upwards, the former at 6.46 percent and the latter at 9.84 percent, just a whisker under double-digits.
One answer is, of course, obvious: the US Fed's decision not to taper its bond buying programme eliminated fears of a premature end to easy global liquidity which could have yanked billions of dollars out of emerging markets like India. The squeeze on gold and falling oil imports due to the economic slowdown also helped reduce the demand for dollars in the short run.
But while the free fall in the external value of the rupee has been checked by favourable external developments and unfavourable internal growth dynamics, the disconnect between the external and internal values of the rupee needs some explanation, especially when it comes with inflation-depressants such as a bountiful harvest, slowing demand and falling consumer confidence.
The answer lies in two basic realities: costs that are yet to be fed through (especially energy); and unmitigated inflationary expectations against the backdrop of a government that has given up on governance and a Reserve Bank of India that has been impotent in the face of huge fiscal follies all through UPA-2 and which is likely to continue in the run-up to the 2014 elections. When inflationary expectations remain untamed for years on end, all economic actors - consumers, investors, businessmen and even governments - start budgeting for higher and higher prices, making inflation a self-fulfilling proposition. The only remedy is to bring down growth by whatever means.
The system needs a shock - and the only tool available is the interest rate. It needs to go up by an unexpected 0.5-1 percent to get the attention of all economic actors and tame inflation.
The Reserve Bank Governor has a crucial role to play at this juncture in our political economy even though monetary policy has been particularly unsuccessful in containing inflationary expectations in the last three years, partly due to timidity and delayed action, but more because the fiscal support needed to make monetary action work was completely missing. On the contrary, the demands from the finance ministry have been for lower interest rates, a policy that could only have worsened inflationary expectations.
Among all economic actors right now, only Raghuram Rajan has freedom of action. And his job is to send the right signals to markets and politicians.
The first thing is to realise that in a political economy, the RBI has to play the role of risk manager. Rajan has to correct for political risks to the rupee and its value. He has to decide on a course of action that will counter those risks. Currently, the prime risk is that politicians will try to spend their way back to power in an election year - and UPA-2 is surely likely to do this in the months ahead.
The second thing to realise is that the RBI Governor will temporarily be more powerful than the political executive- especially given the likelihood that the present government may not return to power or it may return with a depleted majority and an even messier coalition. No politician will have the guts to oppose an upright Governor trying to do his job of containing inflation. And Governor Rajan is currently in the honeymoon period with this government -honeymoon is the time when spouses have to set the rules of conduct in the interests of living happily ever after.
The third thing is to realise that no one in this government has any real authority to act at this juncture to work on policy formulation that will improve supplies and productivity-both factors that can ease inflation. This government certainly has paralysed itself, and the way the CBI has been going about filing FIRs against all and sundry, and the way the Supreme Court has been constraining the executive from acting in critical areas, there is clearly nobody in charge.
But Rajan is in charge of the RBI, and there is no questioning his authority or credibility.
The best thing he can do is to fire a warning shot across the horizon that will curb government excesses. He should raise interest rates steeply-perhaps by 0.5-1 percent, so that everyone knows that he means business.
By doing this in his next monetary policy, he will ensure that government does not borrow cheap and spend irresponsibly when inflation is high and rising. The government will be forced to cut expenditures or raise the prices of energy to reduce subsidies.
He will tell savers that he is working to ensure that their money retains its value. Savings will start rising - a prerequisite for the investment cycle to start again.
He will tell the markets that he is in charge-and that his goal is to lower inflationary expectations.
He will tell the world outside that India will defend the rupee's purchasing power. No one can predict or control the external value of the rupee, but if you defend the internal value by lowering inflation, the markets will take note.
Higher rates may lower growth further in the short-to-medium term, but it will set the stage for longer-term sustained growth. Without controlling long-term inflation, infrastructure investment cannot revive. By its very nature infrastructure projects are long-gestation projects with low rates of return. The only way to get them going is to bring inflation down. 10 percent inflation would make most infrastructure projects viable – this, and not only delayed clearances, is what is responsible for projects failing to take off.
Most important, by raising rates Rajan will send the message that there is at least one Indian institution that is in charge, doing its job.
Right now, the political system needs a solid kick in the pants to shake it out of inertia and arrest the economy’s downward spiral. Only Rajan has the moral authority to do that right now.
The writer is editor-in-chief, digital and publishing, Network18 Group 
