deepak mohanty : monetary policy response to recent inflation in india speech by mr deepak mohanty, executive director of the reserve bank of india, at the indian institute of technology ( iit ), guwahati, 3 september 2011. * * * the assistance provided by g. v. nadhanael is acknowledged. i thank the indian institute of technology ( iit ), guwahati and mr. ankit khemka, convenor, techniche 2011, for inviting me to address such a talented and bright group of youngsters. i propose to speak to you about inflation which is a matter of concern to all of us. it has been about two years since october 2009 that the reserve bank of india announced its exit from the crisis - driven accommodative monetary policy stance. however, inflation continues to remain elevated, despite sustained monetary policy action. headline inflation, measured by year - on - year changes in the wholesale price index ( wpi ), averaged 9. 6 per cent in 2010 – 11 and it has continued to be over 9 per cent in the current financial year so far. this spell of high inflation has been the longest since the mid - 1990s. it has, therefore, posed a major challenge for policymakers, especially for the reserve bank as the key objective of monetary policy is price stability. why do we need to worry about inflation? how did the inflation dynamics evolve over the past two years? what was the monetary policy response? these are primarily the questions that i will address. why do we need to worry about inflation? we need to be concerned about inflation as it has adverse impact on the real economy. first, high and persistent inflation imposes significant socio - economic costs. given that the burden of inflation is disproportionately large on the poor, high inflation by itself can lead to distributional inequality. therefore, for a welfare - oriented public policy, low inflation becomes a critical element for ensuring balanced progress. second, high inflation distorts economic incentives by diverting resources away from productive investment to speculative activities. third, inflation reduces households saving as they try to maintain the real value of their consumption. consequent fall in overall investment in the economy reduces its potential growth. fourth, as inflation rises and turns volatile, it raises the inflation risk premia in financial transactions. hence, nominal interest rates tend to be higher than they would have been under low and stable inflation. fifth, if domestic inflation

remains persistently higher than those of the trading partners, it affects external competitiveness through appreciation of the real exchange rate. sixth, as inflation rises beyond a threshold, it has an adverse impact on overall growth. the reserve bank ’ s current assessment suggests that the threshold level of inflation for india is in the range of 4 – 6 per cent1. if inflation persists beyond this level, it could lower economic growth over the medium - term. these costs, therefore, necessitate monetary policy response to control inflation. how did the inflation dynamics change? it is important to appreciate the background in which the inflation surge has occurred. the current phase of high inflation followed the global financial crisis, which affected the india ’ s economy, though not with the same intensity as advanced countries. managing inflation in an reserve bank of india annual report 2010 – 11. bis central bankers ’ speeches economy which is recovering from a downturn is much more complex because of associated uncertainties than managing inflation under normal conditions. prelude to current inflation surge in the initial phase of the crisis, it appeared that emerging market economies ( emes ) were better positioned to weather the storm created by the global financial meltdown on the back of their substantial foreign exchange reserve cushion, improved policy frameworks and generally robust banking sector and corporate balance sheets. however, any hope about emes escaping unscathed could not be sustained after the failure of lehman brothers in september 2008 which triggered global deleveraging and heightened risk aversion. eventually, emes were also adversely affected by the spillover effects : first through contraction in world trade and then from reversal in capital flows. india, though initially somewhat insulated from the global developments, was eventually impacted significantly by the global shocks through all the channels – trade, finance and expectations channels. in response, the reserve bank swiftly introduced a comprehensive range of measures to limit the impact of the adverse global developments on the domestic financial system and the economy. the reserve bank, like most central banks, took a number of conventional and unconventional measures to augment domestic and foreign currency liquidity, and sharply reduced the policy rates. in a span of seven months between october 2008 and april 2009, there was unprecedented policy activism. for example : ( i ) the repo rate was reduced by 425 basis points to 4. 75 per cent, ( ii ) the reverse repo rate was reduced by 275 basis points to 3. 25 per cent, ( iii ) the cash reserve ratio ( crr ) of banks