inflation, monetary policy should respond. determining whether the supply shock is temporary or structural is a frequent challenge that eme central banks confront. there is a possibility here of both type i and type ii errors1, and either type of error can be costly in terms of foregone growth and loss of welfare. 12. another important reason why managing the growth - inflation balance in emes is a bigger challenge is because of their relatively higher poverty levels. inflation, as we all know, is a regressive tax, and it hurts the poor the most. on the other hand, the most effective way of reducing poverty is through higher growth. but higher growth is sustainable only in an environment of price stability. drawing the right balance between combating inflation and supporting growth is a complex challenge that eme central banks face. 13. estimating the potential output is another factor that complicates the management of the growth - inflation balance in emes. this is a difficult task everywhere, but is particularly difficult in emes because of large under - utilized capacity coexisting with supply constraints. consequently, it is difficult to get an accurate estimate of the output gap and of the excess demand embodied in it, making the challenge of monetary policy calibration that much more complex. 14. i could go on with several other examples to illustrate how the growth - inflation dynamics in emes are structurally and analytically different from those in advanced economies. the short point is that eme central banks have to tread the growth - inflation knife edge with much greater judgement and caution than advanced economy central banks because of the several known unknowns and many unknown unknowns. type 1 : no monetary policy response to a shock that turns out to be structural. type 2 : aggressive monetary policy response to a shock that turns out to be temporary. bis central bankers ’ speeches ii. central banking in a globalizing world managing the impossible trinity 15. let me move on to the second issue, about how globalization has complicated macroeconomic management for eme central banks, as indeed demonstrated by the crisis. 16. as the crisis erupted, it spread ferociously from the sub - prime us markets to financial markets around the world, demonstrating the interconnectedness of national financial systems and the spillover impact of external developments on domestic policy actions. importantly, central banks found that sentiment and confidence were remarkably correlated across countries. 17. in a globalizing world, external developments interact with the domestic economy in complex, uncertain, and even

supply shock could have an adverse impact on expectations and hence the medium - term inflation outcome. we have seen it recently. as the global economy recovered from recession in 2009, commodity prices, particularly food and oil prices rebounded raising headline inflation in many countries. however, headline inflation soon moderated in many advanced economies, as inflation expectations remained well anchored, besides significant negative output gap. of course it is difficult to measure and interpret inflation expectations in a developing country like ours. however, the rbi ’ s quarterly household inflation expectations surveys conducted in select urban centres suggest that inflation expectations in india have remained elevated in double digits for quite some time now. 3 the broad consensus in policy analysis is that while one could look through the first round direct impact of supply shock induced inflation, policy should respond to the second round effects so that the inflation process does not get generalised. “ … the direct role of monetary policy in combating food price pressures is limited, but in the face of sustained high food inflation, monetary action may still be warranted to anchor inflation expectations. ” 4 to sum up, the nature and composition of food inflation has changed in the recent years. as per capita income has increased the demand for food has shifted towards protein, fruits and vegetables. as supply response has not been adequate, there have been price pressures. in addition, the agricultural sector experienced cost - push both in terms of increasing price of material inputs and labour. let me conclude with some thoughts on the way forward so that the food economy does not pose a major constraint on the path of non - inflationary growth that could be sustained over the medium - to long - term. first, there is substantial wastage of agricultural produce, particularly perishables like fruits and vegetables which needs to be minimised by improving the supply chain logistics by setting up cold chains and processing facility at producing clusters. second, there is a need to further liberalise agricultural trade by modifying agricultural produce marketing committee ( apmc ) acts by state governments and even exempting perishables like fruits and vegetables from the provisions of apmc to give wider access to both producers and traders for better price discovery. please see http : / / www. rbi. org. in / scripts / publicationsview. aspx? id = 15423 for the latest results of the inflation expectation survey of households. subbarao, d., ( 2011 ), “ the challenges of food inflation ”, presidential address at the annual conference of the indian society of agricultural