I consider myself privileged to have led one of the finest central banks in the world during an intellectually vigorous period.

For analytical purposes, macroeconomic developments over the last five years can be divided into three distinct phases: (i) The global financial crisis and RBI’s response; (ii) exit from the crisis and RBI’s struggle with growth-inflation dynamics; and (iii) the external sector strains which have accentuated over the last few months and RBI’s efforts to restore stability in the currency market.

First Phase (2008-09)

Crisis management: Given all the water that has flown under the bridge since then, the Lehman crisis of 2008 seems an eternity away. Yet, that was the reality that I faced within less than two weeks of taking over as Governor.

In order to appreciate that perspective, just throw your mind back to those heady days of 2008. Growth was surging along at 9 per cent. Fiscal deficit was on the mend. The rupee was appreciating and asset prices were rising. There were inflation pressures but the general perception was that inflation was a problem of success, not of failure. Most importantly, we thought we had ‘decoupled’ -- that even if advanced economies went into a down turn, emerging market economies will not be affected. The crisis dented, if not fully discredited, the decoupling hypothesis. Why did India get hit? The reason was that by 2008, India was more integrated into the global economy than we recognised.

Second Phase (2010-11)

Exit from crisis: India recovered from the crisis sooner than even other emerging economies, but inflation too caught up with us sooner than elsewhere. Supply pressures stemmed from elevated domestic food prices and rising global prices of oil and other commodities. Demand pressures stemmed from rising incomes and sudden release of pent up demand as recovery began. We were caught in the quintessential central banking dilemma of balancing growth and inflation.

In response to the inflation pressures, the RBI reversed its crisis driven accommodative monetary policy as early as October 2009 and started tightening.

We have been criticised for our anti-inflationary stance, ironically from two opposite directions. From one side, there were critics who argued that we were too soft on inflation, that we were late in recognising the inflation pressures, and that even after recognising such pressures, our ‘baby step’ tightening was a timid and hesitant response. Had the RBI acted quickly and more decisively, inflation could have been brought under control much sooner.

From the other side of the spectrum, we were criticised for being too hawkish, mainly on the argument that there was no need for the RBI to respond to inflation driven largely by food and supply shocks, and that we only ended up stifling growth without easing inflation pressures.

Let me respond to this criticism from both ends of the spectrum.

To those who say that we were behind the curve, my simple response is to recall the context of the years 2010 and 2011. Much of the world was still in a crisis mode, the Euro Zone crisis was in full bloom and there was a lot of uncertainty globally. And as we learnt from the experience of the 2008 Lehman episode, we remained vulnerable to adverse external developments. Our ‘baby steps’ were therefore a delicate balancing act between preserving growth on the one hand and restraining inflation on the other.

With the benefit of hindsight, of course, I must admit in all honesty that the economy would have been better served if our monetary tightening had started sooner and had been faster and stronger. I say that because we now know that we had a classic V-shaped recovery from the crisis, that growth had not dipped in the Lehman crisis year as low as had been feared, and that growth in the subsequent two years was stronger than earlier thought.

But remember, all this is hindsight whereas we were making policy in real time.

Let me now respond to the doves who argue that the RBI was too hawkish in its anti-inflationary stance.

First, I do not agree with the argument that the RBI failed to control inflation but only ended up stifling growth. WPI inflation has come down from double digits to around 5 per cent; core inflation has declined to around 2 per cent. Yes, growth has moderated, but to attribute all of that moderation to tight monetary policy would be inaccurate.

India’s economic activity slowed owing to a host of supply side constraints and governance issues, clearly beyond the purview of the RBI. If the Reserve Bank’s repo rate was the only factor inhibiting growth, growth should have responded to our rate cuts of 125 bps between April 2012 and May 2013, CRR cut of 200 bps and open market operations (OMOs) of Rs1.5 trillion last year.

Admittedly, some growth slowdown is attributable to monetary tightening. Note that the objective of monetary tightening is to compress aggregate demand. But this sacrifice is only in the short-term. Indeed, low and steady inflation is a necessary precondition for sustained growth. The RBI had run a tight monetary policy not because it does not care for growth, but because it does care for growth.

Critics of our monetary tightening must also note that our degrees of freedom were curtailed by the loose fiscal stance of the government during 2009-12. Had the fiscal consolidation been faster, it is possible that monetary policy calibration could have been less tight.

And now let me respond to the criticism that monetary policy is an ineffective tool against supply shocks.

My response should come as no surprise. In a $1500 per-capita economy --- where food is a large fraction of the expenditure basket -- food inflation quickly spills into wage inflation, and therefore into core inflation. Indeed, this transmission was institutionalised in the rural areas where MGNREGA wages are formally indexed to inflation. Besides, when food is such a dominant share of the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.

As it turned out, both these phenomena did play out - wages and inflation expectations began to rise. More generally, this was all against a context of consumption-led growth, large fiscal deficits, and increased implementation bottlenecks. If ever there was a potent cocktail for core inflation to rise this was it. It is against this backdrop that our anti-inflationary stance in 2010 and 2011 needs to be evaluated.

Third Phase (2012/13)

External sector pressures: As inflation began to moderate yielding space for monetary easing to support growth, we got caught up with external sector strains over the last two years and a sharp depreciation of the rupee over the last three months. There has been a growing tendency to attribute all of this to the ‘tapering’ of its ultra easy monetary policy by the US Fed.

Such a diagnosis, I believe, is misleading. We will go astray both in the diagnosis and remedy, if we do not acknowledge that the root cause of the problem is domestic structural factors.

What are these structural factors? At its root, the problem is that we have been running a current account deficit (CAD) well above the sustainable level for three years in a row. We were able to finance the CAD because of the easy liquidity in the global system. Had we used the breathing time that this gave us to address the structural factors and brought the CAD down to its sustainable level, we would have been able to withstand the ‘taper’. But what drives the CAD so high? Basic economics tells us that the CAD rises when aggregate demand exceeds aggregate supply. But we need to recognise that the CAD can increase substantially even in a low growth environment if supply constraints impact both growth and external trade.

The only lasting solution to our external sector problem is to reduce the CAD and to finance the reduced CAD through stable, and to the extent possible, non-debt flows. Reducing the CAD requires structural solutions -- RBI has very little policy space to deliver the needed structural solution. They fall within the ambit of the government. In the interim, we need to stabilise the market volatility, a task that falls within the domain of the RBI.

It is the avowed policy of the RBI not to target a level of exchange rate. Our efforts over the last few years, particularly the last three months, have been to smoothen volatility as the exchange rate adjusts to its market determined level so as to make the near-term cost of adjustment less onerous for firms, households and banks.

But our actions were consistent. Our capital account measures were aimed at encouraging inflows and discouraging outflows. Also, we tightened liquidity at the short end to raise the cost of short-term money so as to curb volatility. At the same time, we wanted to inhibit the transmission of the interest rate signal from the short end to the long end as that would hurt flow of credit to the productive sector.

It is not the policy of the RBI to resort to capital controls or reverse the direction of capital account liberalisation. The measures that we took did not restrict inflows or outflows by non-residents.

(Excerpts from the Nani A. Palkhiwala memorial lecture by the RBI Governor on August 29.)

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