The country's central bank finally got aggressive in its fight against inflation this month, raising interest

rates by half a percentage point. For the last 15 months, year-on-year wholesale price inflation has stayed above 8%, sometimes entering double digits. Figures released show April inflation continuing the trend at 8.7%. RBI has been reacting slowly to the build-up of these inflationary pressures. So, in and of itself, this month's move is praiseworthy. At fault is the attachment to the concept of core inflation. It is believed that changes in the prices of non-food, non-fuel items are what really matter, since inflation caused by food and fuel is beyond RBIs control. Though the price level started accelerating in late 2009, the RBI only raised rates beginning March 2010, and then only in baby steps of a quarter percentage point on eight occasions until this month. Factoring in the latest hike, the central bank's benchmark rate, at which it lends to commercial banks, now stands at 7.25%. That means that with headline inflation averaging around 9%, this rate has been below zero in real terms for 15 monthsand perhaps longer. Yet the RBI insisted that most of the headline inflation in the past year has been driven by exogenous "supply shocks." Left to the mercy of global oil at $100 a barrel, along with a 2009 drought that battered food supplies RBI argued that altering interest rates won't accomplish much. Hence, RBI preferred to look at core inflation, which remained subdued for most of 2009 and 2010. Yes, a central bank has little power over a weather shock that changes the price of, say, rice relative to general prices. But a regular supply shock doesn't last 15 months. Nor does it change the general price level. What changes general prices is money. If money were tight, households would reduce expenditure of other items when they were forced to pay for more expensive rice, thereby keeping the general price level constant. RBI has stoked more inflation by tightening slowly. RBI seems to think that stripping away erratic supply factors is the best measure of real price pressures and expectations in the economy. But that misjudges how ordinary people react to expensive food and fuel. These apparent "non-core" items affect core expectationsperhaps more in a developing country where these items make up the lion's share of household expenditure. Workers will expect generalized inflation because the food on their dinner plates becomes more expensive. They will demand higher wages and, in turn, producers will demand higher prices. So it was only a matter of time before expensive food and fuel spilled over into other prices. The RBI's measure of core inflation has been blinking red since December, edging up 7.3% year-on-year in March and 6.3% in April. That was RBIs motivation for his larger-than-usual hike this month. Yet, because RBI has been slow to act, it now has to contend with people's expectations getting out of control. The RBI's survey on inflation expectations published last month show that people expect up to 13.1% inflation by the end of this year. These altered expectations filter down to economic decision making. Despite the promise of 8.6% growth for India's economy, investors are wary, since capital earns low real returns. Inflation paralyzed the country's financial system in December: Indians began pulling money out of lowinterest-bearing bank deposits, causing a temporary, yet powerful, liquidity squeeze. To repair this short-term damage, the RBI this month raised the rate on savings accountsa rate the government still regulates. The best way now, though, for RBI to repair long-term inflation expectations, as well as the credibility, is by staying clear of the very concept of core inflation. The RBI has to keep tightening, no matter the next oil or food shock. The prices of rice and gasoline, and perhaps other commodities and assets too, matter no less for economic agents than the prices of TVs and iPhones. Self-imposed blinders like core inflation will only hide this core truth from view.

Nature/Source of Threat Continued investment slowdown

Likelihood Strong investment growth will require speeding up government decision making and approvals, as well as substantial progress on the reform agenda.

Expected Impact on Economy Lower investment would reduce potential GDP growth, dimming Indias long-term prospects. A continued slowdown would lead to rising NPAs and other financial stresses, and would add to fiscal risks. Should inflation rise again confidence in macroeconomic management could harm investment, while disinflation could require substantial monetary tightening, weighing on growth. Investment and confidence are already weak, and a deterioration in the global outlook would cause further damage, while a drying up of financial markets would complicate the financing of the current account deficit and cause severe domestic dislocation, at least in the short term. With less policy space than in 2008/09, it is unlikely that countercyclical policy could be as effective as during the GFC. Crowding out could hurt investment, while microeconomic distortions from further market interventions could depress productivity. Interest rates would likely rise, but with a captive investor base the risk of a serious financing crisis is limited.

Inflation remains high and volatile

Supply constraints could cause prices, especially of food items, to accelerate once base effects dissipate. Also, momentum indicators are mixed.

Renewed global financial turmoil and prolonged slowdown in advanced economies

The global situation remains highly uncertain and volatile. India would be exposed to potential negative developments through trade and especially financial channels.

Fiscal expansion

A large expansion of Indias social programs without compensating measures could widen the fiscal deficit considerably.