Raising the interest rate is an attempt to signal to all relevant economic agents and those who set wages and the price of goods and services that the RBI will not relent until it has inflation under control. The RBI wants to emphasise that it sees high inflation as anti-growth.

The RBI should be commended for staying the course that it has laid down for itself. But it must be asked whether the RBI (and UPC) is correct in its understanding of the Indian economy and the effects of its monetary policy on rather complex on-the-ground realities.

To get an idea of these complexities, one could start by noting that headline CPI inflation has remained above 9 per cent for the last 60 months with core retail inflation remaining above 8 per cent during this period. Remembering that GDP growth during the earlier 2003–09 period averaged more than 7.5 per cent when inflation was high, it could thus be argued that persistent high inflation can co-exist with both high and low rates of economic growth in India. Adding another dimension to this complexity is the fact that despite the RBI raising the repo rate on four occasions in 2013 and GDP growth slowing down appreciably, inflation, especially retail inflation, remains stubbornly high.

It could be argued that the persistence of high inflation despite the growth slowdown reflects overcapacity in the Indian economy that is not shrinking despite some recent declines in demand. This can only happen if the supply-side or, more specifically, the growth rate of potential output, is also declining. This is a serious and worrisome conclusion because it implies that, in the last five years, government policies, or lack thereof, have actually diminished India’s supply side capabilities.

This could be the result of, among other things, driving down private investment; raising the incremental capital output ratio by locking up capital in unproductive or non-functioning projects; or driving down labour productivity by not generating higher output from the existing labour stock whose nominal wages rise in line with inflation. A key question now is whether the rise in interest rates, by raising the cost of capital and demonstrating an anti-growth bias, could exacerbate the decline in the growth rate of potential output. This would be reflected in investors choosing to invest abroad to avoid policy uncertainties and escape the high cost of capital.

There is also a broader issue about the RBI becoming an ‘inflation targeter’ in an economy in which large parts of the economy are characterised by price rigidities and mark-up pricing. In India, intermediate sectors that have direct impacts on downstream costs and prices such as coal, diesel and electricity are fixed and controlled by government fiat. Similarly, a large number of agriculture prices that cover nearly 30 per cent of agro output including all major cereals and sugarcane are administratively fixed. These prices will not be affected by a softening of demand. Instead, rise in capital costs enters the price fixing formulae and results in a ratcheting up of these prices irrespective of the demand–supply balance. Raising interest rates could, in these conditions, have a perverse outcome.

All these things considered, it is clear that by persisting with its anti-inflation stance, the RBI is signalling sharply that policy measures are urgently needed to improve supply-side capabilities to raise the growth rate of potential output. These include the oft mentioned measures of removing structural impediments to the inter-state movement of agriculture produce; eliminating monopoly control of critical intermediate sectors like coal; raising public investment in productivity enhancing schemes in agriculture; addressing the debilitating infrastructure deficit that makes it impossible for India’s small- and medium-sized enterprises to face import competition; improving governance, especially in the allocation of natural resources, while establishing a transparent and efficient regulatory framework; and reducing the revenue deficit, which inevitably raises the cost of credit and effectively pre-empts private investment.

These measures are 10 years overdue. This represents a huge missed opportunity to achieve sustained high GDP growth rates with a balanced macroeconomic structure. Contrary to what the Finance Ministry has stated, economic growth does not necessarily have to be cyclical or volatile. This has been amply and persistently demonstrated over the last three decades by China. But for India to mimic China it will have to be far more conversant with its own complex realities and not simply imitate paradigms borrowed from advanced economies. Monetary policy is constrained by its limited arsenal of policy instruments. It can hardly be expected to yield high growth, lower inflation and exchange rate stability at the same time. But it should also not be allowed to become dogmatic and lose much needed flexibility to effectively respond to issues that arise in as complex an economy as India’s with its price rigidities and discontinuous behaviour of critical parameters.

Rajiv Kumar is Senior Fellow at the Centre for Policy Research, New Delhi

This article originally appeared here, in India Today.