The RBIs rate action on Friday brings into focus the key questions facing Indias macro economy how big of a threat is inflation? Can monetary policy fix it? If yes, how much should monetary policy tighten?

The governments line of reasoning goes thus the current bout of inflation is mainly driven by food. Since this is mostly a supply shock, as soon as the winter crop hits the markets, inflation will subside. On the other hand, domestic demand has still not fully recovered from the crisis and therefore monetary policy should continue its present accommodative stance, albeit with very gradual and small rate hikes.

The above argument is at best naive, and at worst extremely dangerous. Inflation is a clear and present danger, and that the belated but welcome policy action by the RBI should be buttressed by significant further rate hikes to remove excessive pro-cyclical impetus to the economy and anchor inflationary expectations. This will obviate the need to raise rates more aggressively in the future and risk a hard landing.

Anytime headline inflation numbers reach 10%, inflation is a problem, one exacerbated by four other factors.
First, inflation is significantly higher than what is being captured by the wholesale price index (WPI). The WPI is not an accurate reflector of prices faced by the consumer, as it has a lower weight of food than what is actually purchased, and does not include services.

Indeed, CPI inflation is running in the high-teens, with the last print of CPI-industrial workers at 16.2%. Disturbingly, core CPI (excluding food and energy) was running well above 10% as early as October 2009, and is likely to have accelerated since then. This is because domestic demand is much stronger than external demand, and is captured by the CPI which includes the price of non-tradables (that is services) that are rising faster than the price of tradables (that is manufactured products).

Second, it is not just food prices, WPI core inflation is rising by on average 1% every month, which translates into a 12% annual increase. Demand pressures are rising and pricing power is returning to corporates. With the governments projection of GDP growth at 8.25-8.75% for FY11, the gap between the economys potential and actual output will close rapidly, exerting further upward pressure on core inflation.

Third, inflationary expectations are building up. With headline numbers in double digits, there is grave danger of expectations becoming unhinged. Recent surveys of inflationary expectations are already showing upticks, and the fast disappearing slack in the labour market will add to these pressures.

Fourth, inflation is generally surprising on the upside in rapidly recovering emerging markets. Importantly, core inflation is picking up, albeit from low levels, and heading towards levels observed in the middle of the previous cycle.

Even if the original shock to inflation is supply-side driven, there is a very important role for policy in preventing second round effects via inflationary expectations. It is instructive to go back to the supply shocks of higher oil in the 1970s. After the oil price shocks of the 1970s, those countries which had an expansionary stance going into the shock, primarily the US, found a much higher increase in inflation, and therefore, larger costs of bringing down inflation in 1980-81. In contrast, Germany and Switzerland maintained restrictive monetary policies, and the impact of the oil shock was largely limited to first round effects.

The role of monetary policy should be to pre-empt the second round effects of the supply shock, else they will get incorporated into inflation expectations, which become persistent, and significantly raise the costs of the eventual disinflation.

Urgent action is also necessary due to three other reasons long transmission lags, establishing credibility, and negative real interest rates.

The lags between raising policy rates and activity tend to be long. During the previous rate-cutting cycle, policy rates took a long time to feed through to bank deposit and lending rates, and that too only partially; similarly on the way up, bank rates may take considerable time to react, and from rates to activity will take further time. Policy needs to be forward-looking and cognisant of these lags.

Second is the issue of credibility of the central bank and importance of staying ahead of expectations. If market participants begin forming the view that the central bank is behind the curve, it would reduce the effectiveness of policy actions and call for larger rate moves than originally required.

Third, the yield curve is amongst the steepest it has ever been. Short-term real interest rates are negative, and one of the lowest among emerging markets. The short end needs to move up significantly to normalise policy.
How much tightening should the central bank do? We have tools to measure the misalignment of policy. First, a Taylor-type rule to measure the output-inflation trade-off. The Taylor rule gives an indication of the level of interest rates, if the economy has to grow at potential, and inflation needs to be at the desired level. Our analysis of the Taylor rule suggests that short-term policy rates may need to be raised by 300bps from current levels to normalise policy rates. This can be achieved by both withdrawing liquidity and moving the effective policy rate from the reverse repo to the repo, and partly by increasing the repo rate.

Countries such as India where domestic demand was least affected by the crisis, and are facing the most inflationary pressures, have little reason to continue with crisis level of interest rates and extremely easy liquidity, especially as central banks across the emerging markets either begin to raise rates (Malaysia) or threaten to shortly (Taiwan, Thailand). The RBI needs to continue to raise interest rates through the course of the year to normalise policy in order to prevent inflation from spiralling out of control. If that implies giving up some domestic demand in the near term for the benefit of prolonging the recovery cycle, then so be it.