"We are monitoring the developments carefully, but at the moment it is clear there is a significant component of what may be called imported price shock in the spike in headline inflation.
"We have to analyse how this price shock gets transmitted on the demand side as well as on the supply side and at what point of the economic cycle you are in and then take a measured policy response.
"Inflation in July has now turned out to be higher than we had expected. Some increase was not unanticipated but the increase in price of commodities, specially relevant to our economy, has been significant."
-- Reserve Bank of India Governor Y V Reddy at a National Institute of Bank Management function at Pune, on August 8, 2004.
"It is predominantly a supply shock and we are monitoring it very carefully. As far as the demand side goes, there is no aggravation to constrain it. Several fiscal measures have been taken, the impact of which will be felt later and I am given to understand this will continue."
-- Y V Reddy at a bankers' forum in Hyderabad, on August 27, 2004.
"The hardening of inflation has been mainly on account of the influence of international price movements in respect of crude oils and metals. . .
"Over the rest of the year, pressures from international prices on domestic inflation are expected to moderate.... The overhang of liquidity would also need to be carefully monitored in view of its potential to pose demand pressure on prices."
-- The RBI Annual Report (2003-04), released on August 30, 2004.
These three statements are an interesting study of the language of a central bank. In early August, when the wholesale price index-based inflation rate rose to 7.51 per cent, Reddy said it was imported inflation.
On August 27, too, he spoke about a 'supply shock' when the inflation rate veered around 7.94 per cent. Three days later, the RBI annual report, for the first time, spoke of the 'demand pressures on prices' and 'overhang of liquidity.' This was when inflation touched 8 per cent.
Against this backdrop, the RBI's decision last week to increase banks' cash reserve ratio by half a percentage point in two phases to 5 per cent was not unexpected.
Finally, the RBI is ready to combat inflation (it has risen to a four-year high of 8.33 per cent) by tightening monetary policy. By doing that, it has also admitted that the reason for the rise in inflation is not cost-push alone but demand-pull as well.
The regulator, which was talking about 'imported' inflation only a month ago, is now convinced that with economic activity picking up, easy liquidity in the system could trigger demand-driven inflation.
If that actually happens, a CRR hike alone will not be able to check inflationary pressures. More monetary measures are inevitable.
One thing is certain: the tightening of monetary policy was the last resort before the RBI. Both the government and the RBI over the past two months tried hard to contain inflation in other ways to ensure that economic recovery was not impacted.
The government did its bit by cutting excise and customs duties on oil and steel products. The RBI, on its part, stopped its aggressive dollar mop-up from the market since every dollar bought injects an equivalent amount of rupees into the system. A strong rupee also brings down the cost of import and, to that extent, helps contain "imported" inflation.
The only monetary measure employed so far was the flotation of market stabilisation bonds to drain liquidity. Theoretically, the RBI could have gone ahead with more MSBs. The upper ceiling on MSBs has been raised to Rs 80,000 crore (Rs 800 billion), and it can be raised even further.
But the Indian regulator has not done so. The reason? Barclays Capital, a unit of Barclays Bank, has pointed out that MSB issuance had flattened the yield curve. The impact of the MSBs was felt more at the shorter end (with the yield of the two-year government bond going up by 40 basis points over the past one month) than the longer end (the 10-year rates went up by about 10 basis points).
"Short-term rates matter more for corporate investment than long-term rates and the RBI could be hoping that a CRR cut would have less of an impact on short-term rates than MSB issuance, which tends to take place largely in the zero- to two-year segment of the curve," it has said.
An increase in CRR is expected to spread the pressure for higher rates over longer maturities.
Besides, a CRR increase has no direct cost to the Budget. While interest rate costs on MSBs are borne by the Budget, the cost of remunerating banks' CRR reserves is borne by the RBI.
However, the RBI dividend payment to the Budget will be reduced by the incremental cost of the higher CRR. But the point is that interest rates on CRR are lower than interest rates on MSBs and politically, a lower RBI dividend is a less sensitive issue than higher budgetary expenditures on MSBs.
The Barclays Capital report says that inflation in India is demand-pulled as well as cost-pushed. Citing the example of Korea, which is as vulnerable to high oil prices as India, the report says monetary policy in Korea has been loose, with policy rates at an historical low.
"Yet, unlike Indian manufacturing prices, Korean manufacturing prices are deflating because domestic demand is so weak that firms have not been able to pass the cost increase on to customers."
Steps like duty cuts and allowing the local currency to strengthen can deal with cost but not with demand factors.
While duty cuts did not work, the RBI is expected to continue with the policy of staying away from the foreign exchange market and allow the rupee to rise against the dollar in the near term in order to curb inflationary pressures.
A Bank of America (Singapore) study has suggested that for every 1 per cent appreciation in the currency, the inflation rate goes down by about 0.3 per cent. Extending this theory, the rupee needs to get strengthened to Rs 42 to bring down the level of the inflation rate to 5 per cent.
This may be too much to ask for, but the fact is the Indian unit has gained 0.8 per cent this week and pierced the Rs 46 level to reach a two-month high of Rs 45.9050/ 9150 on Tuesday.
Tightening liquidity is bound to create the ground for a rise in interest rates sooner rather than later and that will bring down demand.
The hike in CRR could be a prelude to a possible hike of its short-term repurchase or repo rate (4.5 per cent) and subsequently the bank rate, which is now at a three-decade low of 6 per cent.
JPMorgan Chase Bank, Singapore, in its latest Asia Economic Research, said that demand-driven drivers of inflation will gradually become more important in the coming months, prompting the RBI to hike rates a quarter percentage point at its October mid-term review and another quarter percentage point hike early next year.
But the rate hike drama may not unfold as smoothly as is being anticipated. Given a choice, the RBI may postpone the hike for as long it is politically acceptable so as to give the maximum possible space for the investment recovery to run its course.
Equally important is managing the government's borrowing programme, which is not even halfway through even after the completion of the first half of the fiscal year. Finally, the regulator is also concerned about the profitability of the state-run banking sector that could suffer if interest rates are raised suddenly.