A steady hand

The second channel through which higher interest rates restrain inflation is through the exchange rate channel. A hike in interest rates can pull in capital inflows as it increases interest differentials with the rest of the world. This can help the rupee to become stronger. A stronger rupee can reduce the price of tradables. These are primarily non-food items,or the core inflation that the RBI has been worried about. Though the effect has been offset to some extent by a rising rupee,WPI manufacturing has increased because of the increase in commodity prices globally. This can be contained by tightening monetary policy as it allows rupee appreciation and hence makes the rupee price of tradables lower. The most important element in this story is a stronger rupee. If,in a scenario of international price pressures,the rupee is kept weak,the WPI for tradables goes up. This will be reflected in higher WPI-manufacturing and put pressure on the RBI to hike rates further. In the present inflationary situation,it is unlikely that the RBI is expecting that food prices will be controlled by higher interest rates. This means the exchange rate channel can be very important. In addition,controlling liquidity will become difficult if the RBI has to purchase foreign exchange to prevent appreciation.